Okay so you just graduated and someone said something about an IRA and your mind immediately jumped to either Ireland or retiring at 70. Fair enough. However, this is one of the most important decisions you’ll make in your life, regardless of whether you work at Target or at your local pool.
So there are two types of IRAs (Individual Retirement Accounts). You pay no taxes on your contributions in the years you make them but owe a big amount in the future when you eventually withdraw from it in a Traditional IRA. However, Roth IRA is the opposite in the sense that you have to pay the taxes first, before anything gets into your account. It grows completely tax-free and is withdrawn completely tax-free when you reach your retirement age.
The trick is that you currently earn less money than you’ll ever earn in your life. Let’s say you are currently making $15,000 from your part-time job, or maybe even $25,000 from your full-time job after college. Your tax rate currently is almost in the basement of the IRS building and there couldn’t be a better place to pay your taxes. Paying 12% now instead of 22% or 25% later is a huge deal over 40 years of compounding.
Let’s take a look at some actual numbers. Say you are 18 and deposit $3,000 in your Roth IRA in the form of Vanguard Target Retirement 2065 Fund. Let’s say your annual growth rate is 7%. The single contribution would turn into $45,000 by the time you become 65 years old. All of this is then withdrawn tax-free and it is basically insane.
Using Traditional IRA, you would only get a tiny tax deduction and save about $360 from the initial $3,000 deposit. When you retire, you owe income taxes on the whole $45,000 you withdrew. Math will clearly not add up here, because your tax rate is so low currently.
However, there are a couple of corner cases. If somehow you managed to earn a salary of $90,000 right out of high school (maybe in the tech industry), then a Traditional IRA becomes slightly more advantageous because of the tax deduction. However, that’s not realistic and it doesn’t make any sense pretending otherwise.
People like to talk about the Roth IRA income limit of $146,000 per single filer in 2024. Well, you are definitely not close to that ceiling and won’t need to worry about it in quite a long time. If you managed to succeed so much in your career that you are above this limit, congrats! You have the best of problems.
Setting up a Roth IRA is super easy. You can set up an IRA with Fidelity, Schwab or Vanguard in 10 minutes using your phone. All you need to do is to link your bank account, choose a low-cost index fund (like FXAIX or VTI), and make a small monthly automated deposit. Even $25 a month means something if you start at 18 because the whole idea about investments is that time is priceless, and you have more of it than anyone else in the world.
Moreover, people will tell you that you have to contribute the maximum amount of $7,000 every year or you should give up on Roth IRA altogether. Completely ignore this piece of advice because even $50 a month makes you way ahead of the people who will start contributing in their 30s. In fact, the only thing that currently matters is the habit.
Roth IRA was created for you. Low income currently, many decades of compounding left, and the option to withdraw your contribution penalty-free in case of an emergency. That’s the safety cushion that Traditional IRA can’t offer.
The only scenario where Traditional IRA might make sense is the possibility of your tax rate being lower when you retire. However, think about this logically. Do you expect to earn less at 65 than you currently earn at 18? The career trajectories speak against this and, moreover, federal tax rates have been increasing for decades.
Well, let’s face the reality. No one is saying that this is going to be the most interesting thing you will do this year. Setting up your retirement account at 18 may range anywhere between organizing your sock drawer and watching old episodes of The Office for the fourth time. However, you 35-year-old self will thank the hell out of you for being boring for 10 minutes.