As a collegiette, retirement is probably one of the last things on your mind. Though you’re probably thinking about your future, it’s unlikely you’re already considering what your life is going to be like when you’re 65!
Although retirement may seem like it’s so many years away that it’s not worth a second thought, looking into setting up a Roth IRA can be a great financial move for someone who is young and in a low tax bracket (that’s you, collegiette!). But before you jump right in and sign up to open your account, HC is here to make sure you know the facts. And we’ve talked with James Phelps, the managing director of Kendall Capital Associates, a business and financial advisory services firm, to get you all your need-to-know info!
The basics
First, it’s important to know the difference between a Roth IRA and a traditional IRA. An IRA is an Individual Retirement Account that allows you to save money and defer the taxes you pay on that money until you’re ready to withdraw it.
“An IRA allows anyone to put aside some money and have it grow over time. How much it grows is dependent on how you decide it is invested, and how ‘risky’ the investment is (a U.S. government bond has no risk but low reward, while a high tech stock could have a high reward but high risk),” explains Phelps. “But – and this is the key – you can only fund your IRA from ‘earned’ (employment-related) income (waitress, investment banker, taxi driver…doesn’t matter), but it can’t be from a gift or from other income.”
The amount of money you can put in an IRA per year is limited to $5,500. Then however much you decide to invest per year is deducted from the income that you have to pay taxes on.
“In a ‘regular’ IRA, you can dead cut the amount you contribute (to the IRA) from your income,” says Phelps. “So, if you made $40,000 a year, and you contributed $4,000, you would only pay taxes on $36,000…That’s not a bad deal, but then when the money grew (and became, in 40 years, something like $40,000) and you took it out, you would then pay taxes on the whole amount (at your then-current rate).”
An IRA would be a good investment for someone who has a steady job making pretty good money, because you could assume that you have a high tax rate now and might have a lower one later on in life. But for collegiettes working part-time, summer or work-study jobs at low wages, it’s probably not the best idea.
That’s where a Roth IRA can come in handy! The main difference between a Roth IRA and a traditional IRA is that with a Roth, you pay taxes on the money you invest now so that when you take it out later (by which time it has presumably turned in to a lot more money), it’s completely tax free. So for a college student with a low-paying job and a low tax rate, you’ll end up paying much less in taxes now than you would on that same amount of money later in life.
“I really think a Roth IRA is the best way for college students to start saving for the future,” says Lauren, a senior at the University of North Carolina. “It doesn’t require putting away a huge sum, but by retirement age there’s a lot of growth potential. It’s a good way to ensure having a little money down the road.”
Getting started
Before you decide to open up a Roth IRA, it’s good to get some advice from an expert. Every collegiette’s financial situation is different, so talking to a financial advisor who’s trained to work with students can really help you to decide what’s right for your unique situation. Try getting a referral from a peer or someone else who has already opened a Roth IRA or a traditional IRA. Once you’ve decided on an advisor who is right for you, call to make an appointment and get on the path to opening your account.
If you decide you want a Roth IRA after some consulting, opening one is fairly easy. The hard part is deciding where you want to open yours. Along with talking to your financial advisor, you may also want to do some research on your own. Here are some questions you should consider: Is there a minimum initial investment and minimum contributions? Are there fees that go along with the account? What investment options are available (stocks, mutual funds, real estate)?
There are some providers who even offer a cash bonus for opening up an account with them, so looking around for the best deal can definitely be beneficial. Try checking out different companies’ websites to find out the information you want to know. Fidelity, Wells Fargo and Schwab are a few good suggestions to look into.
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Investing tips
Once your account is open, it’s time to start investing!
“You have to put it [your income] away i.e., not spend it,” says Phelps. “All the big firms like Fidelity, Schwab, etc. have ‘no fee’ IRAs, and they’re easy to set up, but you have to do it. And you’d have to be smart enough to pay the taxes on it now.”
A good rule is to plan to invest a set percentage of your income, i.e., a certain amount from every paycheck you get, into the account.
“Now that I’ve graduated and am working on getting a full-time job, I’m definitely seriously considering opening a Roth IRA,” says Nicole, a recent graduate of the University of North Carolina. “I think just putting in a bit of every paycheck I get is a great way to start saving for retirement.”
Once you’re in the good habit of investing that percentage each time you get paid and only having the rest of it to spend, it won’t seem like you have to scrape together money for living expenses.
“Saving for your future appears to be more important than ever before (given the lack of clarity about social security, etc.) and the sooner you start the better,” explains Phelps. Consider, in the first year, 6 percent of $4000 only yields $240, but in the 40th year, 6 percent of the amount in the IRA (after it has grown) could be over $2000.”
You have a variety of different investment options in your Roth IRA such as mutual funds, stocks and bonds. To decide what to invest your money in, you should research the risk and possible reward of each option.
Other benefits
Another great aspect of Roth IRAs for collegiettes is that the money you’re saving for retirement can be withdrawn from the account if an unexpected situation arises. This means that if you encounter a financial emergency, you’ll be able to get to some of your earnings.
There are qualified and non-qualified reasons that you can withdraw funds from your Roth IRA, but only qualified reasons allow you to avoid the 10 percent tax penalty (the IRS imposes a 10 percent fine on withdrawals that don’t meet their exceptions for early distributions). Some qualified reasons include paying college expenses, paying medical expenses and paying for the cost of an unexpected disability. However, your account has to have been open for at least five years before any withdrawal reason becomes qualified.
Once you graduate college and get a job, the IRS even allows you to withdraw (without penalties) up to $10,000 of tax-free money from your account to put toward buying your first house. If you’re married, the limit becomes $20,000.
All this means that by opening a Roth IRA early, you’re not only saving for retirement, but also for the not-so-distant future.
A few cons
Although opening a Roth IRA is mostly beneficial, there are a couple drawbacks to it. Once you invest money in your account, it is tied up there and under most circumstances it can’t be taken out until you’re 59-1/2 years old. This means that you don’t have access to that money if another investment opportunity comes around that you’d like to take part in. Basically, you’re saying goodbye to the money in your Roth IRA for the next 40 or so years.
Also, the maximum annual contribution amount for a Roth IRA might not seem like a big deal now, but once you’re older and have a higher paying job, you won’t be able to contribute as high a percent of your income as you might want to.
However, if a Roth IRA doesn’t seem right for you, finding a different retirement plan that does work for you is definitely still important.
Many college students’ financial situations are extremely tight, but finding even just a few dollars a week to invest in a retirement account can bring you enormous benefits as time goes on.
Are you a collegiette who has a Roth IRA? Let us know with a comment below!