Today, I'm going to tell you about a 100% legal way for young people to save thousands on taxes: the Roth IRA. Nearly everyone our age should have one.
The short story:
The Roth IRA is an amazing deal that lets you avoid capital gains tax. If you don't have one yet, I recommend that you open a free Roth IRA at Vanguard and deposit $1,000 - $5,500 into a Target Retirement Fund.
*assuming you’re in the USA, earning a salary between $1,000 and $127,000, and you don’t have high-interest debt
The long story:
- The Roth IRA is a type of investment account created by Congress in 1997
- There is no inherent risk to a Roth IRA. The money can be invested in almost anything you want, such as stocks (risky) or regular savings accounts (not risky).
- Why use it? Any money invested in Roth IRA pays NO TAXES ON INVESTMENT PROFITS! (This starts small, but compounds to HUGE savings.)
- To receive the tax benefit, you must wait until age 60 to withdraw the profits
- However, there is no penalty to withdraw early (though there is a penalty to withdraw profits early)
- The Roth IRA is such a great deal that you're limited to adding $5.5k per year (and if you earn six figures a year (or zero), you might not be eligible at all)
So why open a Roth IRA? What's so good about not paying capital gains tax?
If, from age 24 to 65, you invest $5k per year with a 5% return, you will save $100,000 in taxes. *assuming a 20% capital gains tax rate
(If you live past 65, you'll save even more.)
The capital gains tax is a tax on investment profits. In the plot above, the green curve is how your money grows without tax and the red curve is how your money grows with a 20% capital gains tax.
With different growth rates and tax rates the numerical details may change but the conclusion won't: the Roth IRA is a no-brainer because you'll save thousands on taxes. And there is almost no downside: remember, should you ever need the money early you can withdraw it without penalty.
If you do open a Roth IRA, you'll need to decide how to invest your money. I recommend choosing Vanguard's Target Retirement Index Funds.
Why index funds?
Index funds are the easiest, cheapest, and most diversified way to invest in the stock market. In essense, an index fund is a savings account that follows the stock market. If the stock market goes up, the index fund makes money. If the stock market goes down, the index fund loses money. Usually these swings are between -15% and +20% each year.
Even billionaire investor Warren Buffet says that index funds are best for individual investors; it's the expert and academic consensus. (I plan to write a future post about index funds, so I'll say more then.)
Why Vanguard's Target Retirement Funds?
Vanguard is the biggest and cheapest provider of index funds. Their Target Retirement funds are especially easy to use. Vanguard Target Retirement funds automatically balance across US stocks/foreign stocks/bonds, and they automatically change the balance to be more conservative as you age. And they even do it cheaply, charging only 0.18% per year.
Ok, great. How do you open one?
To open a Roth IRA with Vanguard, go here. The page should look like this:
- Choose "Open a new account"
- Click START
- Choose "No" (assuming you don't already have an account)
- Click CONTINUE
- Click CONTINUE
- Choose "Retirement"
- Choose "Roth IRA"
- Click CONTINUE
- Fill out your personal information
- Click CONTINUE
If someone goes beyond this point and wants to take screenshots, I'd be happy to post instructions for the rest of the process. It's pretty straightforward.
I think at some point they'll ask whether you want an index fund account or brokerage account; make sure to choose the index fund account option. And near the end of the process, you'll also have to pick some funds to put money into. I recommend you pick the Target Retirement 20XX fund that roughly matches your target retirement year. The minimum deposit is $1,000 and the maximum deposit is $5,500 (the Roth IRA contribution limit). And then you should be all set!
Lastly, if you want to invest your Roth IRA money in other funds or assets, that's fine. There are many roads to Rome. The important thing is to make sure that no matter what you're investing in, the assets are inside a Roth IRA.
Let's summarize the costs and benefits of a Roth IRA.
- 10 minutes to read this blog post
- 10 minutes of googling to confirm that what I said is true
- 20 minutes to open an account
- A bit of paperwork/hassle if you ever need to withdraw early
- You will deprive the US government of tax money decades from now
- You can save $100,000 in taxes!
- You can then afford to buy 20,000 feet of Subway sandwiches, stack them end to end in an attempt to build an edible ladder to the moon, fail deliciously, and still be as rich as your neighbor who never opened a Roth IRA
- Did I mention the $100,000?
Opening a Roth IRA is seriously a no-brainer (if you have savings and income). And the sooner you start, the bigger the benefit. So think about it, make a plan, and follow through. You'll be ahead of 90% of your friends.
[If you have any questions about this stuff, feel free to email me or gchat me or Facebook me.]
What if I want to invest in something else?
Go ahead. Although I highly recommend the Vanguard Target Retirement funds as an easy default option, you can certainly succeed with other investment strategies. (But really, at least stick to index funds.)
What about inflation?
Inflation, by itself, doesn't change the analysis much - in fact, it makes the case for the Roth IRA stronger because without one, you end up being taxed on phantom nominal gains. (Contribution limits are indexed to inflation so they are unaffected. The real growth of stock prices should also be unaffected by inflation, for the most part.)
What about Traditional IRAs?
There is also a type of IRA called a Traditional IRA, which is often, but not always, worse than the Roth IRA. With the Traditional IRA, you pay income tax on the money you withdraw and you get to skip paying income tax on the money you contribute. If your tax rates are the same at age 25 and 75, then this makes little difference. But if you expect your tax rates today to be higher than in your retirement, a Traditional IRA may be a better deal. The Traditional IRA has some downsides, though. First, you must pay a penalty if you withdraw early (though there are some exceptions). Second, you are forced to start withdrawing money at age 70.5. Third, the effective contribution limit is lower. Even though Traditional and Roth IRAs have the same contribution limit, post-income-tax dollars go in the Roth IRA whereas pre-income-tax dollars go into the traditional IRA. Since post-income-tax dollars are worth more, the Roth IRA effetively has a higher contribution limit.
How much can I contribute exactly?
How much you can contribute depends on your income. If you make too little or too much, your limits may be different or you might not even be eligible at all. In tax year 2012, the Roth IRA contribution limit was $5,000. In 2013, it is $5,500. The limit is indexed to inflation and rounded to the nearest $500.
If you earn less income than the limit, you can only contribute as much as you earned that year. Make sure your income meets the IRS's definition of earned income, which is not always intuitive. Regular salary and paychecks count, but some other types of income don't (such as scholarships and fellowships, sadly).
If you are (1) Single and earning above $112,000 in 2013 or (2) Married and jointly earning above $178,000 or (3) Married Filing Separately then you can't contribute up to the normal limits. There's a phase-out income range where you can contribute a fraction of the regular limit, and at income levels beyond that you cannot contribute at all. Google for more information if this applies to you.
Are the benefits of a Roth IRA guaranteed?
Because the government can change laws, the benefits are not guaranteed. It is possible that the government could rescind the benefit to boost its tax revenue. I think this is unlikely, but no one can accurately predict the future.