That's the tempting incentive behind Roth IRAs. And millennials are gaining a new appreciation of that simple truth when it comes to saving for retirement, according to a new study from T. Rowe Price. The study shows that investors under 34 years of age have over eight times more money in Roth IRAs than traditional IRAs.
For those unfamiliar with the rules, you don't get a current tax deduction for your contribution to a Roth IRA, as you would with a traditional IRA. But the government promises that all the gains will come out tax-free when you retire! It's such a good deal that there are income restrictions on who may contribute -- only singles with incomes under $114,000 and married couples filing joint returns with income under $181,000 can take full advantage of a Roth contribution.
So give the millennials some real credit for understanding not only the value of regular retirement saving but the importance of avoiding taxes in the future. After all, given our huge deficits and promises of payments to the aging baby boom generation, it's reasonable to assume that tax rates might be much higher when millennials finally retire.
That wasn't the case 25 years ago, when most boomers started thinking about retirement. Back then, it was assumed that when you retired you'd be in a lower tax bracket. And that was before so many programs, including Social Security benefits and Medicare Part B premiums, were impacted by taxable income. Now every bit of taxable income may count against you, not to mention the possibility of rising tax rates.
Compounding Time and Money
There are two good reasons for younger people to opt for the Roth version of the IRA. First, they're likely to be in a lower income tax bracket when they contribute, so the deduction isn't as valuable. But even more importantly, they have a much longer time to make that tax-free money grow. And that's not just a guesstimate.
Here's an example from the study, which assumes investors retired at age 65 and contributed $1,000 to a Roth vs Traditional IRA at various ages. Each is in the 25 percent tax bracket at the time of their IRA contribution. And to make things fair, the $250 tax deduction from the traditional IRA is not spent, but invested in a separate account.
The study also assumes a 7 percent annual return for each of the accounts (as well as that separate taxable account for the $250 annual savings from the deduction). Then during retirement, when most investors become more conservative, the return drops to 6 percent.
Withdrawals are taken over a 30-year retirement. And how is that retirement lifestyle enhanced for the Roth investor?
That 25-year-old who used a Roth and stays in the same tax bracket in retirement would have nearly 20 percent more spendable income in retirement than the worker who used a traditional IRA. That is a significant difference; just ask any retiree if he or she could use 20 percent more income!
There are some other benefits to Roth IRAs. If you've managed to save a lot for retirement, you might not want to withdraw from your IRA, but opt to instead pass it on to your heirs. Traditional IRAs have required minimum withdrawal rates after age 70 1/2. But there is no such requirement for a Roth.
And here's another secret about Roth IRAs that I hesitate to publicize. While an IRA is meant to be untouched until retirement, if urgent circumstances require a withdrawal from a traditional IRA before age 59 1/2, you'll face a 10 percent penalty, plus taxes. Not so with a Roth, where you can withdraw the contribution portion of your account without penalty or taxes.
The IRA Season
We tend to stop thinking about Individual Retirement Accounts after April 15. But that's a huge mistake. The T. Rowe Price survey also shows that those who make their contributions on a monthly basis throughout the year far outperformed those who waited until tax time to make a lump sum contribution.
In fact, using rolling 10-year periods of real S&P 500 stock returns, the monthly contributor generated a larger account balance in 98 percent of those time periods. And the best performance of all was generated by those who made their annual contribution early in the year. In the study, the "early investor" outperformed the monthly investor in 91 percent of the 10-year periods studied!
That means (SET ITAL) now (END ITAL) is the time to be making this year's IRA contribution -- not 11 months from now!
You can contact any mutual fund company or broker to open an IRA in a low-cost, diversified stock market portfolio. T. Rowe Price will let you open an IRA with a minimum investment of $1,000, setting up an automatic contribution of $100 per month or more. The same minimums apply with most no-commission (no-load) mutual fund companies.
But if you're just getting started, don't let the high entry price deter you from starting an IRA. At Sharebuilder.com there is no minimum amount required to open an IRA, although you will pay a $6.95 fee for each investment.
No matter where you open that IRA, you'll get an opportunity to invest in a diverse portfolio of America's best companies, reinvesting dividends along the way, either through a mutual fund or exchange-traded fund.
Once you get started with an IRA account and automatic monthly contributions, you'll be amazed at how easy is to get your money working for you as hard as you worked for it! And that's The Savage Truth.
Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange. She appears weekly on WMAQ-Channel 5's 4:30 p.m. newscast, and can be reached at www.terrysavage.com. She is the author of the new book, "The New Savage Number: How Much Money Do You Really Need to Retire?" "Terry answers readers' personal finance questions on her blog at www.TerrySavage.com. To find out more about Terry Savage and read her past columns, visit the Creators Syndicate Web page at www.creators.com.
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