I’ve been encouraging a couple of twins who I’ve known since they were five to start an IRA since they are now 17 and working a job at a grocery store. An IRA, or individual retirement account, is a little gift from the government that allows individuals to save money either tax-deferred or tax-free. They come in two flavors: Traditional and Roth. A traditional IRA is tax-deferred, meaning you pay no taxes on the money you invest or any of the money you make in the account until you withdraw it at retirement age. With a Roth IRA, you pay taxes on the money you invest, but then pay no taxes on the money you withdraw or the interest it earns.
So how would these little wonders turn a 16 year-old into a millionaire at retirement? Well, if one of the twins were to open an IRA and put $4,000 in it, and then invest entirely in a diversified stock mutual fund like the Vanguard Total Stock Market Fund, it would double in value about every six years. Because it would double eight times between the time they were 16 and 65, every dollar they put into it would be worth $256 when they reached 65. This means that $4,000 would be worth about $1 M at retirement age, even if he invested nothing else after putting the original $4,000 away.
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If he invested in a traditional IRA, he would also save on the taxes on the year he put the money into the IRA. If he were in the 10% tax bracket, he would get to keep $400 more of his money right now, so it is like he gets extra money for making the investment. Went he withdrew the money from the IRA at age 65, however, he would be taxed on the money he was withdrawing. If he were in the 25% tax bracket during retirement, this would mean that he would actually only get $750,000 after taxes.
If he invested in a Roth IRA, he would not get a tax break now, so he would pay $400 more in taxes now. But when he withdrew money at age 65, he would get to keep all of the money he earned, tax-free. This means he would get to keep the whole $1 M. The only catch is that he would need to find the extra $400 to invest. (In fact, if he invested that extra $400 he got to keep from taxes when he invested in the traditional IRA, putting in $4,400 instead of $4,000, he would end up with the same amount of money after taxes as he would have had with a Roth IRA if his tax rate at retirement were the same as it was when he was working.)
For the twins, I’m advising they go to Charles Schwab since they offer an IRA account with a $1 minimum investment. This means they could put whatever they can this year, even if it is only $100, an then add to it as they can. If they could get used to putting in $20 per paycheck, that would get them to a little over $1,000 per year. They could also go to Vanguard, but they require a $1,000 minimum to start. Both are great companies with a wide selection of funds to choose from for investments.
Filling out the paperwork and opening the account only takes 15 minutes or so online. Because they are minors, the twins would need to have a parent be a custodian on the account until they turn 18. After opening the account, they would just need to send in a check or send money from a bank account electronically, then choose investments. At Schwab, I would start with the Schwab Total Stock Market Index Fund (SWTSX). At Vanguard, I would buy the Vanguard Total Stock Market Index Fund if I had the minimum $3000 to invest, otherwise I would choose the 2065 Target Date Retirement Fund which only has a $1000 minimum.
So what else do you need to know about IRAs? Well, there are some important rules:
- You must have earned income equal to or exceeding the money you put into the IRA during the year you put the money in. This means you need to make at least $4,000 from a job or from running a business in 2018 if you want to put $4,000 in an IRA this year.
- Right now you can put in up to $5,500 per year. If you were to put $5,500 away each year between age 16 and age 35, you would be absolutely set for retirement, no matter what else you did financially. (Lone exception, you must not touch the money in the IRA and it must stay invested in a diversified stock portfolio your whole working life.
- If you take the money out early (before retirement age), you’ll pay a penalty plus you’ll need to pay taxes on the money. (Actually, there are a couple of exceptions with the Roth IRA, but why would you want to raid your retirement funds? Just stay invested.)
- With a traditional IRA, you’ll be forced to start taking the money out when you’re about 70 1/2 years old, so you may need to pay some hefty taxes then, especially if you invested a lot more than the original $4,000 and have several million dollars in the account. With a Roth IRA, there is no need requirement to take the money out ever, so you could let it grow for another 30 years and leave it all to your heirs, if you wished.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.