How Roth IRAs Give Gen Y a Fighting Chance

Roth IRAIt’s easy for young adults to get carried away with prospects of starting a career or growing a family in their 20s. However, a major oversight young people make is underestimating how important their youth is when planning for retirement.

With over 35 percent of people over the age of 65 relying on limited Social Security reserves, young professionals should take advantage of their early paycheck-earning years by opening a Roth IRA. The uncertainty of U.S. Social Security presents an increasing need for alternative retirement solutions, like a Roth IRA, to comfortably fund those golden years down the road.

According to the 2012 Retirement Confidence Survey, a staggering 30 percent of American workers have less than $1,000 in retirement savings and investments. What’s more concerning is that of the individuals surveyed, 35 percent felt that they would need at least $500,000 by the time they retire in order to live comfortably.

Saving half a million dollars is no simple feat, especially with potential debt from mortgages, college expenses and credit cards weighing down on many young Americans. However, capitalizing on younger years — particularly between the ages of 20 and 30 — with a Roth IRA can make that $500,000 retirement savings figure much more attainable.

Best Savings Account for Young Adults

The best savings account for young adults isn’t a basic savings account like those provided by banks in tandem with a checking account. Roth IRAs provide years of benefits with relatively simple conditions to adhere to compared to other investment options, making them an overwhelming favorite among most young professionals.

How a Roth IRA Works

Roth IRAs are one of the best investments for young people because of how they are taxed. This type of IRA requires depositors to pay income tax based on their existing tax bracket, and contributions made to a Roth IRA go in post tax. That means when the account holder reaches retirement age, withdrawals (including earned interest) are made tax free.

Typically, young professionals receive their lowest salaries at the start of their careers, and therefore, fall within a lower tax bracket, as opposed to the higher tax bracket they will be placed in as senior-level professionals later in their careers.

With this in mind, Roth IRAs require young adults to pay taxes now — at a lower tax bracket — instead of paying taxes upon withdrawal at a potentially higher tax rate, as with traditional IRAs. New Gen Y professionals, in turn, hold onto more of their retirement savings when it matters most.

Additional advantages of a Roth IRA include:

  • Tax-exempt withdrawals at retirement age (age 59.5)
  • No mandatory distribution age (i.e. if you don’t want to withdraw at retirement, you don’t have to)
  • Freedom to invest in other investment types like a 401(k), stocks, bonds, CDs, etc.
  • The principal can be withdrawn at any time without penalty

As a young adult, there are many factors in life that remain uncertain and the flexibility of a Roth IRA in terms of withdrawals, penalties and diversification are welcomed benefits.

Roth IRA Contribution Limits and Requirements

While a Roth IRA is among the best investments for young people, it is not without its faults. One disadvantage of this retirement savings account is that there are limitations as to who is eligible to open a Roth IRA.

This retirement option is only available to young adults who meet certain income requirements. For 2014, single individuals must make a maximum annual income of $181,000 and married couples must fall below a combined annual income of $191,000.

Further, depositors must be employed in order to deposit into a Roth IRA. For example, left-over birthday gift money or extra student loan awards may not be deposited into a Roth.

Roth IRA contribution limits determine the maximum amount depositors can contribute to their IRA annually. For young professionals who meet the standard adjusted gross income (AGI) requirements, the contribution limits are $5,500, regardless of marital status. Depending on annual income, however, Roth IRA contribution limits may be gradually reduced if your AGI exceeds the maximum amounts described above.

The Roth IRA Movement

Encouraging young adults to take serious strides in securing their retirements via a Roth IRA is a movement that is quickly picking up pace. Jeff Rose of Good Financial Cents is an advocate of Roth IRAs for young professionals and has joined forces with over 140 bloggers, companies and financial websites to educate Gen Y of the virtues of a Roth IRA.

  • retiredinboyntonbeach

    Jennifer Calonia was seriously mistaken when she wrote, “This retirement option is only available to young adults who meet certain income requirements. For 2014, single individuals must make a maximum annual income of $181,000 and married couples must fall below a combined annual income of $191,000.” The fact is that anybody who earns income can put some or all of his or her IRA money into a Roth, every year. Even people who use the SEP-IRA mechanism, which allows you to put in a lot more per year than the traditional IRA limitation, can do this.

    Here’s why she’s wrong, and how you can legally evade the “eligibility limitations” that she described in her article. It’s true that this “eligibility limitation” means that people with higher incomes cannot contribute DIRECTLY into a Roth IRA. However, there’s a perfectly legal but little-known “back-door Roth” approach, called “conversion,” which ANYBODY can use regardless of income. Here’s how it works: you contribute the money directly to a traditional IRA account, then subsequently “convert” the funds to a Roth IRA. If your income is so high that only, some, or none, of the traditional IRA contribution is tax-deductible for you, then you have to pay full income tax on the non-deductible part of money you contribute; that amount is termed “basis” and must be tracked for the traditional IRA (because that part of the traditional IRA will be exempt from taxation upon subsequent withdrawals after age 59 1/2). If you inform your custodial bank or brokerage, they will report the “basis” on the contribution form they are required to send directly to the IRS every year that you contribute to the IRA (they’re supposed to send you a copy of that form each year too). If you leave the money in a traditional IRA, all the growth within the account is subsequently taxable as ordinary income upon withdrawal, regardless of whether it’s interest, dividends, or capital gains. However, if you “convert” your traditional IRA to Roth as soon as possible after the initial contribution, which is all “basis” (already taxed) anyway, your tax due upon conversion is either zero or very little (you’re only required to pay the conversion tax on the excess over and above the “basis” amount). So if you do this every year, you essentially create a Roth IRA for yourself even though you’re not “eligible” to contribute directly to a Roth. It’s a small hassle, a very small hassle, and it requires appropriate reporting on your Form 1040 each year, but wow, it’s worth it! Because inside that Roth, all the growth will be tax-free forever, to you and to your beneficiaries. And if your financial condition is such that you don’t need to withdraw from your Roth after retirement, you don’t have to — not even after you reach 70 1/2 — because there’s no RMD (yet — that law might change in the future). So you can accumulate as much as you can through “conversions” and growth of the account(s), and pass the goodies on to your beneficiaries as you wish — ALL completely income-tax free. And if you do withdraw some money, it’s not only tax-free, but it doesn’t count as “income” for purposes of Medicare premium costs.

    So just because you’re not “eligible” to contribute directly to a Roth because you make too much money, you can still have your Roth. The small amount of bother (keeping official track of basis for the regular IRAs, and reporting the conversions on your income tax filings) is trivial compared to the wealth you can amass and the tax-free income you and your heirs can enjoy by doing it.