Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.
- People who open a Roth IRA early in life have a long investment horizon. The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
- A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year. The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year. This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
- Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
- The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65. This is not always possible. The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time. The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
- All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.
Concluding Thoughts: Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA. Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax. My view, expressed here and in several future posts, is that the Roth IRA should become the default option.