Financial planners across the United States like to say that it is never too early to start thinking about retirement. To many people, this means starting to save for the future when one has a decent career-oriented job and a healthy starting salary. However, saving money for retirement can start even earlier than that; college students with part-time jobs can begin to enjoy the power of compounding interest in a retirement account while they are still in school.
Getting Started on Retirement
For young people, a Roth IRA is the ideal account for retirement savings. In fact, many retirement planning professionals suggest this is the smartest financial move a young person can make. What is a Roth IRA? IRA stands for “Individual Retirement Account” – it is a brokerage or banking account where retirement savings earn interest.
College students who earn even a small amount of income can easily set up a Roth IRA. It is the ideal solution for young people because of the rules governing contributions to and withdrawals from the account as compared to other retirement accounts. Roths penalize account holders for early withdrawals of earnings; as long as the account holder waits until he or she is 59 ½ years of age, there are no penalties. So, time is on young people’s sides…if you can wait until retirement age to begin withdrawing money, the Roth plan might be just the ticket.
There are certain ways people can make withdrawals before the age of 59 ½ without penalty, especially by withdrawing any contributions made to the plan. Withdrawals of contributions can be made at any time, and are tax- and penalty-free. For first-time homebuyers, there’s another perk: as long as the account has been open for at least five years, one can withdraw up to $10,000 to make a down payment on that first home.
Tax Advantages for Young People
A Roth IRA is set up so that any withdrawals after the age of 59 ½ are tax-free. In many other retirement plans, withdrawals or distributions from the account are considered income, which is taxable. Not so with the Roth. That’s a great advantage for those who can wait until retirement age and can save thousands of dollars over the life of the account. The account grows tax-free as well.
The Power of Compounding Interest
Roth IRAs grow value over time. Because these plans use investments in mutual funds, stocks, and other financial products, their value changes as the stock markets rise and fall in value. In general, Roth IRAs can be expected to grow by 8-12 percent every year. Compounding interest works like this: interest is earned on the balance in the account, so as that balance gets bigger, the interest gets bigger, too. This happens even if you aren’t making contributions to the account; the value grows whether or not you are adding money to the balance.
Let’s look at some numbers to make things clearer: imagine that a college student or young employee establishes a Roth IRA and contributes $3000 every year for 20 years. The total contribution over that time period equals $60,000. Now, imagine that you earn $5000 in interest on that balance over the 20-year period.
Here’s where things get interesting. With that $65,000 balance, you invest in a mutual fund (through your Roth plan) that earns 8% in annual interest, a conservative performance figure. 8% interest on a $65,000 account balance in the first year equals $70,200, for an increase in value of $5200. This increase in value happens even though you haven’t made a single dollar of contributions to the plan.
The next year, you earn 8% interest on the new balance of $70,200. That interest adds up to $5616, making the total value $75,816. In two years, without doing anything, you’ve earned close to $11,000 without doing a thing. And, those earnings grow tax-free.
So, it’s clear that the longer you own a Roth IRA, the longer this compounding interest will benefit you. It is critical to make contributions to the plan for the first years; most retirement planners suggest making the maximum contribution allowed by law for at least the first 20 years of the plan.
Rules for Roth IRA Holders
As with anything, there are rules for Roth IRA holders. These rules can impact what you can and can’t do with the plan.
Most importantly for young people, Roth IRAs require earned income to make contributions. In other words, gift money from parents or an inheritance from a grandparent cannot be used to contribute to a Roth plan. Neither can money left over from student loans. You must have a job, and that income is the only money that can be used to contribute to a Roth.
For earners, the maximum annual contribution to a Roth plan is $5,500. And, you can’t save more than you make in income. So, if you only earn $2000 at a part-time job, you would only be allowed to contribute $2000 to such a plan.
There are income limits at the high end, too. For single taxpayers who make less than $118,000 or married couples who own a Roth jointly making less than $186,000 combined, the maximum contribution for 2017 is the full $5500. If you make more than the income limits, you are not allowed to make as large of an annual contribution. The more you earn past the caps, the smaller the contribution allowable by law. This has little impact on young people and early-career workers, but it is something to consider over the long term.
Final Word on Roth IRA Plans
There are a lot of upsides and few drawbacks to establishing a Roth IRA plan as a young person. Time is on your side, and you can expect to work for the next 30-40 years before retirement. In that time, provided you make regular annual contributions to the plan, you might just retire as a millionaire! College students with part-time jobs may not have a lot of extra income with which to start saving for retirement, but every little bit helps. It’s never too early to start thinking about your future; one of the best ways young people can prepare for retirement is by speaking to a financial professional. He or she can give you the guidance you need to make smart financial decisions, helping you toward a comfortable and financially-stable retirement in your future.