Before I invest in a given year, I allocate my money to a retirement savings account.
Yes, a retirement savings account.
I treat this retirement account as the huge piggy bank from Squid Game. As each year passes, my investments grow and compound. More importantly, I get to keep all of my gains…TAX-FREE.
One of the best financial tools for almost every young individual is a Roth Individual Retirement Account (Roth IRA).
A Roth IRA is an individual retirement account (you can invest in this account) in which you make after-tax contributions to the account and then make tax-free withdrawals in the future.¹ As your portfolio increases in value, you will be able to withdraw your gains tax-free.
- The current contribution limit (as of 2023)is $6,500 a year for those under the age of 50 and once you reach a certain yearly income you can no longer contribute to a Roth IRA.²
- Since this is a retirement account, you cannot withdraw any of the gains until you are 59 ½ years old. If you withdraw your gains early, then you will face a 10% early withdrawal fee and income taxes, thus losing most of your gains. Account holders can withdraw contributions made to the account; however, the contribution cannot be replaced. If you put in $6,500 in February and then take out $1,500 the same year in April, you cannot add $1,500 back into the account and will have to wait until next year to contribute.
Now that you understand the basic idea of a Roth IRA, here are the unique features:
- With a Roth IRA, your gains grow tax-free. Your yearly contributions are after-tax dollars, and the gains in your account grow tax-free. If you rely on a regular retirement savings account (Traditional IRA), then you are taxed on your gains. Your tax rate will be based on your current income when you withdraw. In today’s age, most Gen Zers (a good portion of Millennials too) are focused on having multiple streams of income or climbing the corporate ladder. Regardless of the path, it is likely that your future income will increase. Furthermore, based on historical income tax rates, taxes are currently at a low rate. It is possible for future tax rates to increase, as the government will need to generate revenue (increase taxes or print more money) to pay for future obligations and debts.
- My favorite feature of the Roth IRA is that it helps you become a better investor. One common attribute among good investors is the ability to be patient. All good investors are patient, but it is difficult to acquire the skill when get-rich-quick schemes are all over social media platforms. Since you cannot use the gains until the age of 59 ½, you are less likely to withdraw contributions and gains from your Roth IRA. Thus, even if a stock plummets, you can wait it out as the stock value will most likely rise. In 2020, I bought $5,000 worth of Tesla for around $850 each. A couple of months later, it dropped to $600 per share. My heart dropped, too. While I was eager to sell and take my losses, I decided to just let it sit there since I was in no rush to withdraw my money. Tesla is a well-known company, and I had faith it was not going to drop completely to $0. It was not until the stock surpassed my initial purchase price of around $850, the company hit an all-time high of around $1,230.
- A Roth IRA does not have to be boring unless you like boring. For most people, investing in an S&P 500 ETF for an average annual return of 10% (more like 7%-8% due to inflation) will be the safest investment for them. You can simply place your money in the account and never look at it until next year’s contribution. Others might be interested in only investing in tech or penny stocks, in hopes of big rewards. Those that are really innovative, will create a company and buy shares of their company with the hopes of taking the company public and turning their Roth IRA into a $5 billion piggy bank. If you do not believe me, have a look at this video from ProPublica.
- The best part of a Roth IRA is that there is no mandatory withdrawal requirement. While you can withdraw your gains at the age of 59 ½, you do not have to. Instead, you can leave your money there until you die and pass it on to your family members or loved ones. If you are one to really think long-term, your family members can be multimillionaires.
LET’S RUN THE NUMBERS
With compound interest, anyone can become a millionaire. Look at the table below, if you start funding your Roth IRA in 2023.
WHAT WOULD LUV DO?
Currently, I have a Roth IRA. In 2019, I decided to start my wealth journey and open an account. A Roth IRA can be open with most banks such as Bank of America, Fidelity, Charles Schwab, and more. I decided to go with Charles Schwab because they are known for their great customer service. Since I had money invested in an individual brokerage account, I transferred $6,000 to my Roth IRA for 2020 and then made another full contribution in 2021. So far, I was able to receive a 17% return which increased my portfolio by $1,976.26.³ While it may not seem like a lot, the important part is that I was able to get a return above 10%.
Fast forward to 2023….
If I could go back in time, I would open a Roth IRA once I started receiving a W-2 form. Every year I would put the full contribution into my account, or as much as I could (something is better than nothing).
When you live long enough you can enjoy the money once you hit 59 ½ years of age, and if die early, then your kids will be millionaires…sounds like a win-win to me.
For those that have not started, open an account in 2024…it is never too late to invest. If you cannot contribute $7,000 your first couple of years, that is totally okay…the main goal is to get started.
Love,
Love
Notes
¹ For traditional retirement accounts, you can reduce your yearly taxable income by making contributions. Traditional retirement accounts, such as a Traditional 401(K) or Traditional RA, are known as pre-tax retirement savings plans. When it comes time to withdraw, account holders will be taxed at their current income tax rate.
² Information regarding a Roth IRA changes over time, visit https://www.investopedia.com/terms/r/rothira.asp to stay up to date on current Roth IRA rules.
³ Although I currently have a 17% return on my investment, it fluctuates daily due to increasing and decreasing stock prices. The goal is to ensure that your portfolio is performing at or above 10% return.