With final exams in May and June for colleges, universities and high schools, thousands have marched for their graduation ceremonies. Whatever the age of your graduate, you should introduce them to the power of the Roth IRA. More than anything, it is an incredible gift to the young with their low taxes and time on their side. With Roth IRA accounts you invest money with a mutual fund company or brokerage firm. You don’t get the upfront tax break as you do with a traditional IRA or 401(k), but you get back something more valuable in the form of tax free growth for the rest of their lives.
Grads can deposit up to $5,500 into a Roth every year, as long as they have earned that much income for the year and have an adjusted gross income under $120,000. If you have the extra cash flow, I recommend the “parent match” for the Roth IRA to get them up to their maximum contribution. Convincing your grad to salt away funds for the future may not be the easiest sell. See if you can use the following points to convince them.
The Power of Starting Now. If there’s one thing that a college grad has on most of us, it’s time. Let’s say they were able to put $5,500 a year into their Roth IRA for the next 10 years. After that they stop their contributions. If you assume 9% annual growth in the account, by the time they reach retirement 30 years later they will have $1.1 million in their account. All of that growth came out of $55,000 of contributions.
If instead they wait for 10 years to get started on the Roth and then make 30 years of $5,500 contributions, the numbers look good but not as compelling. With that same 9% growth, your grad would end up with $750,000 in their account 40 years from now. And they had to make $165,000 of contributions. Start your grad saving now to get over $1 million in tax-free growth versus less than $600,000 if your grad starts in 10 years.
Tax-Free for Life. Putting funds into a Roth IRA instead of a traditional IRA is a wager that taxes in the future will be higher than the taxes they pay today on income. With your new grad most likely in a low-income tax bracket and the recent tax law changes, this is a good bet to make. Once you put funds in a Roth IRA, you will never have to pay taxes on them again as long as your withdrawals are qualified. For most people that means waiting until age 59½ before they access their Roth earnings. Unlike traditional IRA and 401(k) accounts, with a Roth your grad won’t have to pay income taxes on the proceeds when they need the funds.
You Can Get It Back. Life often happens while you’re making plans. What if your grad ends up needing the funds? They may worry that if they require the Roth money for other purposes, it will be unavailable in some sort of retirement vault. A little-known trick of the Roth IRA allows your grad to withdraw the contributions that were made into the account. We consider Roths to be tax-free gold and don’t generally recommend this step. But if you need the money, you can always get your Roth IRA contributions out free of tax or penalty regardless of your age or circumstance.
Dave Gardner, CFP®, EA