When you're young, starting an individual retirement account may be the furthest thing from your mind. But for millennials, those born from roughly the early 1980s to the late 1990s, a Roth IRA may be an ideal investment vehicle to ride.
There are three big reasons why.
The younger you start, the better
Thanks to compounding, getting a head start on investing is always a good idea -- and this Roth IRA calculator can show why. A Roth IRA allows contributions up to $5,500 a year ($6,500 if age 50 or higher). A married 45-year-old earning $100,000 a year and contributing the maximum each year until age 67 would have $244,000 in retirement savings at an average 6% annual return. Not bad, right?
Let's say that person started 10 years earlier, when he or she earned $80,000 a year -- by age 67, the person could have $518,000 saved. Much better.
Now let's imagine that person started when he or she was single at age 25, earning $60,000 a year. Drum roll, please: By retirement, at age 67, that person could have more than $1 million saved. The sooner you start, the more compounding works for you.
No taxes on future income
The best part of Roth IRA savings -- compared with other retirement accounts like a traditional IRA or even a 401(k) -- is you aren't taxed on the cash you withdraw in retirement.
Going back to the retirement savings calculator, you can see the tax savings that result: Our 45-year-old investor would save about $42,000 in taxes.
Our 35-year-old would save an estimated $130,000 in taxes, and our 25-year-old would have an estimated tax savings of more than $339,000 when he or she retires and draws the money out. Of course, you have to weigh the tax savings in many decades against putting tax-deferred money away now in a regular IRA. And if you have a 401(k) with an employer match, that should be your initial go-to choice for retirement savings, so that you fully capture that match first.
Better for early withdrawal (if you must)
Ideally, no one should treat their retirement savings as a piggy bank, to be cracked open in case of emergencies. That erodes the impact of compounding. In fact, retirement accounts like a 401(k) and traditional IRA have a 10% penalty for withdrawal before the age of 59½.
That said, if you have to dip into your retirement savings, a Roth IRA is ideal because there is no penalty for early withdrawal of contributions, although investment growth is another matter (read how Roth IRA withdrawal rules apply). An important exception to that rule: First-time homebuyers can withdraw up to $10,000 of contributions and investment growth from their Roth IRA for a down payment, if the account has been open for at least five years. (The government is generous with its description of "first-time homebuyers" -- anyone who hasn't owned a home the previous two years qualifies.)
Again, caution is always required when dipping into your retirement savings early. Over 40 years at 7% interest, that $10,000 for a home down payment could have swelled to nearly $150,000. Still, a Roth IRA invested in the broad stock market has a much greater likelihood of higher returns over five years compared with cash parked in a savings account.