Adam had just finished up his first month of work, and after enjoying a happy hour with his new colleagues, he came home and perused the pile of mail on the table. He smiled at the familiar handwriting on a greeting card and opened it eagerly to find a graduation card with a handwritten note and a check.
“Did you wonder where your graduation gift was? You know I’d never forget my guy! Pick me up at 9:45 tomorrow morning; we have an appointment at 10 nearby. Bring the check! Love, Gram xo”
Puzzled, Adam stared at the check. It was for $6000, made payable to Charles Schwab and the memo said “ROTH IRA.” At that moment, his mom walked in, saw his confusion and asked what was going on.
Adam replied, “I don’t know. I think Grandma might be getting confused. She sent me a check meant for someone else and she has two random names in the memo. Who are Ruth and Ira, anyway?”
His mom giggled and said, “I’ll let Gram explain it, but I can assure you she is not getting confused!”
The next morning, Adam dutifully picked up Margaret and followed her directions to an office building in the center of town. As they headed toward the building, Margaret remarked, “Alright, now that we’ve got the 401K covered, it’s time for your next tip… Contributing to a Roth IRA.”
“A Roth IRA?” Adam wondered aloud.
“Only the single most powerful tool in your retirement arsenal… in my humble opinion!” Margaret said with glee.
Adam smirked as he followed his grandmother into the building, ruefully recalling the conversation he had with his mom. “Of course, Gram knew what she was doing,” he thought to himself, “I’m obviously the only one who is confused here!”
Adam and Margaret were greeted at the door and directed to an office, where it was obvious that the advisor was expecting them. “Hi, Margaret! And you must be Adam! I’ve heard so much about you. I’m Susan,” the advisor said as she extended her hand and continued. “I understand congratulations are in order on both graduation and your new job! Come, sit down.” Adam mumbled his thanks and took his seat obligingly.
“I’ve been working with Susan for years,” Margaret confided. “Not only is she a fee-only Certified Financial Planner which was important to your grandfather and I, but she provides the best service around. And now, she’s going to help you get started!”
“Adam, your grandmother tells me that she’d like you to open a Roth IRA. I understand that you’ve already begun to contribute to a 401K at work, so you have a little bit of an understanding of retirement accounts, but I’d like to start by asking if you know what a Roth IRA is.” When Adam shook his head, Susan continued, “Ok, let’s start there then.
“Put very simply, a Roth IRA is an Individual Retirement Account that is funded with after tax contributions. Then when you are of retirement age, you can withdraw the money, including earnings, tax-free. There are limits on how much you can contribute each year and some rules about withdrawing the funds, but that gives you a quick overview. Do you see how that is different from your 401k, Adam?”
“I think so,” Adam said. “I know that my 401K contributions come out before taxes, which helps to reduce my taxable income for tax time. But I thought that the 401K also grew tax-free?”
Susan replied, “That’s right. The difference though is that the 401K grows tax-free, but it’s actually tax-deferred, meaning that while you won’t pay taxes on the earnings each year, you will eventually have to pay income tax on the withdrawals. Let’s look at a real easy example:
“Let’s say in year one, you contribute $5000 to your 401K and $5000 to your Roth IRA. To keep it simple, let’s say you don’t contribute to it again. With an 8% growth rate, that money can be expected to grow to over $50,000 in time. If you withdraw the whole balance from your 401K at 59 ½ years of age, you can expect to be taxed on $50,000 in additional income. However, because the money you contribute to a Roth IRA has already been taxed, and because of the structure of a Roth IRA, you will not pay a dime in taxes if you withdraw that entire balance at age 59 ½. “
At this point, Margaret jumped in. “That’s why I told you the Roth IRA is such a powerful tool!”
Susan added, “Well, there are a few exceptions to that if you withdraw the money early, but we will cross that bridge if we get to it, ok?”
Adam laughed and said, “Gram would probably disown me if I withdrew it early!” They all laughed as Margaret threw her hands up, exclaiming, “Well!”
Susan continued, “Okay. Let’s get started with the application. You are well within the income limits, so you can contribute up to the maximum of $6000, and this check will cover that. I’ll call you sometime in December to set up a monthly contribution amount for next year, so you should take some time to think about how much you can afford to do. You see how powerful a Roth IRA can be, so you want to take advantage of it as much as possible while you can!”
As they wrapped up the meeting and headed back out to the car, Adam gave Margaret a quick hug and said “Thanks, Gram. That was pretty awesome.”
Lesson 3: Open a Roth IRA – As soon as feasible and before your income exceeds the limit, open and contribute to a Roth IRA, up to the annual maximum (currently $6000 in 2019 with an additional “catch up” contribution of $1000 allowed if you are over 50 years old). This will give you great flexibly and tax advantages upon retirement.