Q. I am twenty-one years old and am thinking about opening an IRA. I am single, earn about $30,000 per year, but have no 401K plan at my job. Is an IRA the best way for me to save for retirement, and if so, should I open a Regular IRA or a Roth IRA?
— James, Virginia
A. James, first of all, you are to be commended for thinking of planning for retirement at a young age. Many people put off their retirement planning until they are almost retired, and at that point, it is extremely difficult to adequately prepare.
At your age, your best friend is time. To use an example, if you can average 8% return on your investments over time, your money will double roughly every nine years. That means that if you invest $4,000 toward your retirement today and earn 8% annually, your account will be worth $8,000 when you are 30. That may not strike you as too exciting, but the numbers begin to be much more interesting in time. Again, assuming an 8% return on your money, at age 66 your investment will be worth about $128,000. Now consider investing $4,000 every year for the next forty-five years, and your account will be worth around $1.5 million.
Contrast that scenario with someone who starts investing at age 51. If he invests $4,000 per year for 15 years, his account will only be worth about $108,000 at age 66. So as you can see, your best friend is time.
To specifically address your question about which investment vehicle to choose, let me briefly explain the difference between Regular and Roth IRA’s. Whether Regular or Roth IRAs, Individual Retirement Accounts are tax-preferred accounts that are established by an individual person for the purpose of providing for his or her retirement.
But while they are both tax-preferred, in one case, the tax is merely deferred until the investor withdraws the money, while in the other, the money is withdrawn tax-free.
The money within a Regular IRA grows tax-deferred. Tax-deferred growth means that money grows in a tax-sheltered environment, so instead of paying taxes on capital gains and interest as the account grows, the taxes are deferred until the money is withdrawn.
When an investor contributes to a Roth IRA, he is not entitled to any up-front tax deduction. However, a Roth IRA does have something going for it that the regular IRA does not. Money with a Roth IRA does not grow tax-deferred; it grows tax-free. Tax-free growth means that no taxes must be paid as the account grows in value, nor is there any tax assessed on money when it is withdrawn. Tax-free growth is clearly more beneficial than merely tax-deferred growth. And considering that your investment horizon is a number of decades, I would suggest that you open and fund a Roth IRA.
Thanks for the question.
(John Clark is a Registered Investment Advisor and a nationally-recognized expert in the field of ethically-responsible investing. You may email him questions for this column at jclark@lasalle-st.com or call him directly at 1-888-764-2423.)
