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Written by: Justin Daniel Lawlor
Everyone wants to retire to a life of leisure and financial stability. After all, the “American Dream” must end in some manner. You work hard, buy a home, establish credibility through merit, raise a family, and at sixty-five you retire to a beach house, careless days of golf, and freedom that was unknown during your working years.
Of course, consuming martinis on the beach does not warrant a paycheck. Years of relaxation must be financed in one way or another.
Current retirees at least have a steady in-flow of monthly Social Security payments, but can our generation expect the same level of assistance?
Fortunately, the federal government and the IRS have blessed American individuals with a powerful gift to face the challenges of retirement saving: the Roth IRA.
The Roth IRA (Individual Retirement Account) may very well be the single most efficient tool for building long-term wealth. Although you may be reading along and thinking, why should I be worrying about retirement when I haven’t even begun my career yet? Allow me to elaborate on the purpose of the IRA, and the answer to that question will become evident.
The Roth IRA allows individuals to contribute a maximum deposit each year, which is invested and accumulates exponentially with time, and can be tapped into at the age of fifty-nine and a half. But the kicker is that your withdrawals are tax-free.
That is decades upon decades of contributions, reinvested dividends, and capital gains distributions compounding without Uncle Sam taking his cut. Earnings in the form of a paycheck will be taxed before funds are deposited into the IRA, but that is at the tax rate of a low-income college student. And tax rates will undoubtedly be higher in fifty odd years when it comes time to begin IRA withdrawals (Medicare/aid, stimulus plans anyone?)
For the 2009 tax year the maximum Roth IRA contribution is $5,000 (the deadline for contributions is April 15). Next year the minimum will increase to $6,000, and in subsequent years the maximum will rise by $500 to counter inflation.
Furthermore, one of the best features of the Roth IRA is the flexibility that individuals hold in regard to what types of investments they wish to hold in the account. Your Roth can be made up of stocks, bonds, ETFs, mutual funds, index funds- the same cannot be said for a 401(k) or a 529(b).
Now, let’s have a look at the power of a Roth IRA’s compounding potential. Assuming that you are 20 years old, contribute the maximum deposit of $5,000 this year and up your contribution by $500 each year as the maximum increases, and earn a conservative 7.0 % rate of return on your investments, by age sixty-five your account balance will read $3,842,944.57.
Looking back, you would have only actually deposited $797,000 into the account. So where did the ending balance of $3.8 million come from?
Well, by year sixty-five your account would be earning an annual dividend payment of $251,407.59. It is time and tax-free interest compounding that allow for a Roth IRA to accumulate at such a stunning rate.
So what’s the downside? This account almost seems too good to be true, no? Well the fact of the matter is that most young adults are lazy. They won’t take the hour or two necessary to set up a Roth IRA account, and will therefore squander their greatest asset: time.
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