For students and young professionals, you don’t have to wait until you have access to a regular 401(k) plan to start saving for retirement.
You can use a Roth IRA to be tax-smart about saving money from the moment you start earning any income. Eventually, you may earn too much to use a Roth account—but before that day happens, there are some great reasons to use it while you can.
What is a Roth IRA?
A Roth IRA is a kind of tax-advantaged retirement account designed for individuals with earned income up to $117,000—that means it’s a great fit for people are just starting out in their career.
The Roth IRA is not an investment itself but a type of account that has some tax advantages to encourage you to save for retirement.
With a Roth IRA you contribute after-tax income, so you don’t deduct contributions on your tax return—but when you withdraw the money in your retirement-age years, you won’t have to pay taxes at all on that cash. You also don’t pay any taxes on investment gains each year, also known as tax-free growth.
Here’s why Roths are so great especially for 20-somethings: If you have earned income (wages, salaries, bonuses, or money earned from self-employment) up to $117,000 in 2016, or are married and filing taxes jointly with an earned income of up to $184,000, you can contribute up to $5,500 annually to a Roth IRA. You can also set up a spousal Roth IRA for a non-working spouse, effectively doubling the amount you can contribute each year.
Even if you’re earning much less than this upper limit, you can still contribute up to the amount you have earned. Earn only $4,000 last year in odd jobs while a student? If your income was less than $5,500, you could contribute up to the amount you have earned.
(By the way, traditional IRAs are also great—but you’ll have plenty of time to use one when you move into a higher-earning bracket.)
There are more reasons to love a Roth account. Here are some of them:
1. You can contribute to both a 401(k) and a Roth IRA. The great news is you don’t have to decide—you can contribute to both. In simple terms, the Roth IRA saves you on taxes in the future—while your traditional 401(k) saves you on taxes today. It’s good to have a mix of both situations. If your employer makes matching contributions, contribute enough to the 401(k) to get the full match before adding to your Roth IRA. For 2016, the max you can contribute to your 401(k) if you’re under 50 is $18,000; the max to a Roth is $5,500.
2. You can withdraw up to $10,000 without penalty or taxes for a first-time home purchase. The $10,000 you can withdraw includes any contributions you have made—and this sum can be withdrawn without taxes or penalty at any time. The funds must be applied directly to the home acquisition (such as down payment and closing costs), and the Roth account must have been open for five years.
3. Funds for qualified education expenses for you, your spouse, your children, or grandchildren can be withdrawn penalty-free. There is no limit on the amount that can be withdrawn for qualified education expenses. While you must pay income taxes on the withdrawals (and be mindful you’re also losing out on future investment returns), if you are younger than age 59 1/2, there is no “early” withdrawal penalty. In most cases, qualified expenses include tuition, fees, books, supplies, equipment, and room and board.
4. You have more control over your investments. Unlike 401(k) plans, where you have a limited set of investments determined by your plan sponsor, you have more control over what you can invest in—as in the types of funds—and that is a way you can keep closer tabs on the costs.
5. A Roth IRA conversion is a great thing to take advantage of while you’re in graduate school or any other time you have low income. If you are in a period of low income, whether for graduate school or because of a period of unemployment, you can think about doing a Roth conversion and move money from your 401(k) into a Roth. When you convert, you’ll have to pay income taxes (as you’re moving from a pre-tax contribution account to an after-tax one), but since you’re in a low-income tax bracket for the moment, you’ll be paying as few taxes as possible. The big idea here is that you’re likely to be in a higher tax bracket down the road, even in retirement, as compared to your graduate school days—so take advantage of your low tax bracket while you have it.