(PUB) Investing 2015

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his IRA and is funding a 401(k) at work. My daughter’s IRA, smaller because she’s younger, is also growing (I matched her earnings too). And yes, after a job change, she’s got a 401(k) as well. Okay. That’s my kids. What about yours? Let’s go back and review my thinking on the teenage Roth IRA, so you won’t put this off. It’s important and especially timely given that the April 15 deadline for contributions seems to sneak up quickly on those who’ve pro- crastinated about making their deposits. The Roth IRA is an excellent retire- ment savings vehicle for younger peo- ple. Since their introduction in 1998, Roth IRAs have been garnering respect (and dollars) from knowledgeable investors for the advantages they have over traditional IRAs. While a traditional IRA allows you to deduct your contributions pre-tax, it also locks your money in until you are 59½ years old (unless you feel like paying a 10% fee on withdrawals, plus income taxes), and forces you to take distributions upon reaching the age of 70½, paying income taxes at your future—and possibly higher—tax rate. In contrast, when contributing to a Roth IRA, you invest with after-tax dol- lars now and can withdraw funds tax-free after the age of 59½ or if you meet other IRS qualifications (for instance, if the distributions will be used for a first-time home purchase—something today’s kid might appreciate tomorrow—or to help with a disability). Once you do hit retirement, there is no requirement on distributions—if you don’t feel like tak- ing money out or don’t need it, you can leave it in there to continue growing. Why do I continue to preach the benefits of IRAs as great starter invest- ments for teenagers or young adults? Simple: Taxes and the power of com- pounding. If your child is only working for the summer, or just starting their professional career, they will likely be in one of the lowest tax brackets, mak- ing it a fantastic deal to pay taxes on their retirement savings now as opposed to when they are older and in a higher bracket. And, in this economy, many first-time jobs don’t come with 401(k) retirement plans attached, so there’s no

Roth IRAs Age Well

$1,000 A Year $1,000 $24,673 $225,508 $417,822

$2,000 A Year $2,000 $49,345 $451,016 $835,645

$3,000 A Year $3,000 $74,018 $676,524 $1,253,467

$4,000 A Year $4,000 $98,690 $902,032 $1,671,289

$5,500 A Year $5,500

Gradual Increase

Age

15 30 60 70

$1,000 $37,284 $612,935 $1,174,517

$135,699 $1,240,295 $2,298,023

Assumes a 6% annual rate of return.

and gain employment: Starting with their first summer job at age 15, they invest $1,000 a year until they gradu- ate from college and get settled into a career, bumping their contribution up to $2,000 a year at 23. By age 30, they will (hopefully) be well-established and able to again bump their contribution up to $4,000, and at 40 bump it up again to $5,500, an amount they continue to contribute up until retirement. You can see that the greater the con- tribution and the greater the time that’s passed, the larger and faster the account grows. That is the power of compound- ing—by constantly adding to your investment, you increase the potential return, going from what seems like a paltry $1,000 initial investment at age 15 to $225,000 by age 60, simply by adding $1,000 a year to the account, achieving a 6% annual return and paying no taxes on your income and gains. With larger initial (and subsequent) investments, you get even more bang for your buck. But I also put together another sce- nario that may be more realistic, par- ticularly when we’re talking about real markets and real teenagers. First off, few teenagers are going to be able to earn $5,500 in a summer, though they might be able to hit that number or high- er if they work during the school year. Also, as you know, markets don’t compound in a straight line. They go up and down. So, in the charts on the next page, I’ve assumed that our teen (or guardian angel) is not only socking away more modest sums, but does so from the age of 12 to the age of 25, when, presum- ably, Junior will be out working, saving and investing on his or her own. In the three scenarios, I’ve assumed the actual returns from Total Stock Market , Total Bond Market and Wellington from 2001 through 2014.

other available vehicle for forced retire- ment saving. Plus, for most, an IRA gives you more flexibility over where and how to invest. 401(k)s often have few, and sub-par, investment choices. The power of compounding is what really makes any kind of tax-deferred investment smart. The definition of com- pounding is “the act of generating earn- ings from previous earnings.” While I know you know what that means, here’s how I’d think about explaining it to a younger investor: Let’s say you make a $100 investment in a fund that rises 20% in a year. After that year, you’d have $120. Instead of selling your shares, you let them ride, and the fund gains another 20% the next year, bringing your investment value up to $144. That’s an additional $4 in gains over the first year (or 4% on the original $100 investment) generated because you gained 20% not only on your original investment, but also 20% on all the money you earned in the first year. While this may not seem like an impressive amount, with each passing year that earnings poten- tial grows even higher, so long as the investment prospers. If you start actively investing a set amount each year, add- ing to the amount generated by what the investment earns on its own, you create even larger potential earnings. In the table above, I set up several different savings scenarios for illustra- tion. All of them assume a 6% annual return, with the difference in scenarios being the amount contributed per year, increasing in increments from $1,000 to $5,500 (the maximum currently allowed under IRS rules for investors age 49 and younger for 2014 and 2015) from the age of 15 to 70. Finally, the sixth scenario attempts to show a conservative, natural progression a young person might follow as they age

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