Why you should open a Roth IRA now

I recently wrote an article for Interest.com on 5 reasons you should open a Roth IRA now.

Aside from a checking account, it is by far the single best account to have and the best way to save. It’s an Individual Retirement Account that not only provides you with tax-free income in retirement but offers you a lot of flexibility to make penalty-free withdrawals between now and then.

At a time when Americans lack not only retirement savings but emergency savings, the Roth is great because it lets you pull double duty by saving for both in one place.

In a perfect world, you’d never touch the money in a retirement account until your working days are over.

But in these economic times people don’t often have a choice. Everything from layoffs to medical bills can put a pinch on everyone.

If you have to tap most retirement funds, it can get quite expensive.

Withdraw money from a 401(k) or traditional IRA before you reach 59½, and you’ll be hit with a 10% penalty and have to pay income taxes on whatever you take out.

If you need $5,000, for example, you might have to actually withdraw $6,500 because of those penalties and taxes.

That’s not the case with a Roth IRA.

You can withdraw contributions anytime, for any reason, without paying any penalties or taxes.

That’s one of the reasons Mari Adam of Adam Financial Associates in Boca Raton, Fla., says that opening a Roth IRA is one of the best financial moves you can make.

If you’re like most Americans, you’re probably lacking in both your emergency and retirement savings.

So if you have to play catch-up, using a Roth as part of your emergency fund lets you do both simultaneously.

“It gives you flexibility to where if you need it in an emergency or for something important, you can access the principal for any reason tax-free and penalty-free,” Adam says.

Second, a Roth can help you save for college bills and a down payment on a home. This is especially important if you’re young and haven’t yet bought your first home because you can withdraw up to $10,000 to put towards a down payment and not pay any taxes or penalties.

Some parents are using Roth IRAs to hold some of their kids’ college education funds because the contributions can be withdrawns at no cost whenever the money is needed.

They can also tap the earnings and the 10% penalty is waived if it goes to cover a qualified higher education expense. This includes college tuition or expenses for you, your spouse, your child or grandchild.

A Roth IRA is also one of the greatest tax breaks you’ll ever get from Uncle Sam because your earnings can grow tax-free and be withdrawn tax-free in retirement.

Think about it: Your money can grow for decades, and you’ll never be taxed on it.

At 59½ years old, you can start withdrawing from this jackpot when all your friends with traditional IRAs have to pay taxes on every dollar they touch.

If you’re 30 years old and max out your Roth IRA to the current limit for 30 years and average an 8% return, you’ll have $608,000.

If you used the 4% rule, that would provide $24,000 a year, tax-free.

If you were in the 15% tax bracket, and had to pay taxes on your withdrawals, it would be about the equivalent of $30,000 per year.

Of course, contributions to Roth IRAs must be made with after-tax earnings.

This is one of the biggest differences between a traditional IRA and a Roth IRA.

With a traditional IRA, contributions (up to the $5,000 limit or $6,000 if you’re over 50) can be deducted from your earnings, lowering your income tax bill for that year.

But unless you’re in a higher tax bracket, you really wouldn’t see much savings with a traditional IRA anyway.

If you’re in the 25% tax bracket and contributed $5,000 to a traditional IRA this year, you could save up to $1,250 in federal income taxes.

But would you actually save and invest that difference?

Probably not. If you’re like the majority of Americans, it would be absorbed into your annual spending on things like dining out, clothes and cell phone bills.

With the Roth, you won’t save any money in taxes now, but you’ll be able to grow that money for decades and never pay taxes on any of it.

Finally, with a traditional IRA, you must start making withdrawals by age 70½.

There is no such requirement for Roth IRAs. You’d be lucky to be in this situation, but you can hold this tax-free money indefinitely and pass it on to your heirs.


 

How much should you be putting away every month for retirement?

When I recently wrote about knowing your retirement goal number, I received a lot of feedback via email, blog comments and comments on Linkedin.

Some were positive, some were negative. Some implied that there are jut too many factors to calculate that number. While that might be true it shouldn’t stop anyone from at least trying to figure out how much you need in retirement. Even if that’s 40 years away and so many things can change between now and then, having a number gives you a goal to aim for.

Most importantly, having that number lets you work backwards to figure out how much you should be putting away now every month towards retirement.

Where do people start? And how can a regular Joe or Jane sitting at home come up with a rough number to find out how much they need to be saving now?

I recently wrote a story for Interest.com that breaks that down into four step system to calculate your monthly retirement savings.

Step 1. Estimate how much you’ll need per month in retirement

Start with you income. You’ll want to have an average of how much you make annually throughout your working life.

You might be making $40,000 a year now, but by the time you retire 20 years from now, you might be making $70,000 a year.

So, your average annual income might end up around $55,000 a year.

When you retire, you hopefully will have paid off your house, won’t be supporting kids and will have fewer expenses than you do now.

But most experts agree you need to replace at least 60% of your pre-retirement income to continue your lifestyle.

That’s $33,000 a year, or $2,750 a month in today’s dollars.

But you’ll also have to account for inflation, which typically runs 3% a year. So, to have the same purchasing power of $33,000 in 25 years, you’ll actually need $69,000 or $5,750 a month.

Step 2. See how much you can expect from Social Security.

Now that you have an estimate of how much you’ll need every month, see how much you might get from Social Security.

Visit the Social Security benefits estimator to estimate how much you’ll receive.

It will give you three numbers based on whether you plan to start collecting benefits at age 62, 67 or 70.

The longer you wait to start collecting, the more you’ll get per month. If you collect at age 62, you could receive up to 45% less than if you wait until you’re 70.

Of course, a lot depends on how much you pay into the system. As your income rises over the next 10, 20 or 30 years, so will your benefits.

You also have to remember that things are a little shaky with Social Security. If you’re under 40, a lot can happen between now and retirement.

There’s a good chance they’ll raise the retirement age or reduce benefits. They could do both. It’s likely that the system will also pay a smaller cost-of-living adjustment.

Take a look at the four changes that might be in store for Social Security that I recently wrote about.

To be safe, you might want to anticipate receiving 10% less than what’s stated on the estimator.

So, if the estimator says you’ll receive $3,000 a month when you turn 67, let’s change that to a $2,700 monthly benefit.

Step 3. Find your gap and how much you need to fill it

You need to find out how much of a difference you have between what you can expect with Social Security and what you need in retirement.

In the old days, Social Security benefits might have covered most of your needs, but today you’ll be lucky if it covers half.

Sure, you might be able to pinch pennies and scrimp by on your Social Security payment, but is that really how you want to spend your golden years?

In the example above, you’ll need to come up with approximately $3,000 a month of your own money to meet your retirement goal’s monthly income.

That’s still a lot of money, but it’s better than trying to come up with the full amount.

This is when you need to take advantage of the 4% rule.

It says you can take out 4% of your savings the first year of retirement and the same amount, adjusted for inflation, each year after that.

In theory, your money should last 30 years.

Using the 4% rule, to come up with $3,000 a month or $36,000 a year, you’ll need to have $900,000 socked away.

That’s a whopping number, but remember you have 25 years to reach that goal. And even if you don’t meet it (you likely won’t), you’ll still want to come as close to that number as possible.

It won’t be the end of the world if you don’t make that number.

Since Social Security will be covering almost half of your retirement income, failure to make that goal will have a smaller impact than you might imagine.

Say you only end up with $600,000 by the time you retire. That’s a whopping 33% less than you were aiming for, but it will only represent about a 16% reduction in your retirement income.

In any case, you want to get as close to your goal as possible. Saving regularly, often and early can help you grow your nest egg through compounding.

Step 4: Work backwards to figure out how much you need to save each month.

Finally, take that big number and deduct for any retirement savings you already have. So, if you have $40,000 socked away already, you’ll aim to put away $860,000 by the time you retire.

If you have 25 years to go and assume that your fund will grow at the historical stock market average of 8% a year, you’ll need to put away $7,500 a year.

That’s $625 a month.

Of course, all of these variables could change, especially your return.

If you socked away $625 a month and averaged a 9% return, you’d end up with over $1 million. Or you’d have $724,000 if you averaged only 7%.

Interest.com’s Savings Goal Calculator makes these kind of calculations easy.

Just remember that a lot of things can change over the years, but you need to have a target to work with.

Do you know your retirement goal number?

How much do you need to save to retire?

To retire comfortably, you’ll need enough savings to replace at least 60 percent, and preferably 80 percent, of your pre-retirement income.

If you make $65,000 per year, want to retire about 30 years from now and replace 70 percent of your income for 25 years, you’ll need to save a whopping $2 million.

This number probably seems shocking and almost impossible. Now that you see what kind of challenge you’re facing, use it to motivate all of your future decisions.

The cold, hard reality is that only one out of four of you reading this will actually reach “your number” in retirement. Just remember: Even if you can’t possibly save that much, the more you have, the better it will be. Retiring with half of your goal is a lot better than retiring with none of it.

And it also underlines a constant message we stress throughout this book—you need to do your best to save as much as possible as early as possible and let compounding work in your favor.

How much can you really expect from Social Security?

William Hammer, Jr., CFP, Vice President of Wealth Management for Vanderbilt Partners, says you need to start by figuring out how much you can expect to get from Social Security. You should get a statement in every year which gives an estimate of what you can expect to collect in retirement. If not, check out this calculator to estimate your benefits.

If you were born in 1976 and average $40,000 per year throughout your work life, you could expect to collect $1,043 per month at age 62. That’s in today’s dollars—in 2038, adjusted for inflation, you would receive about $2,857 per month.

But remember, if you’re younger than 45, there’s a darn good chance that your Social Security benefits are going to be less than they would be now.

“If you’re a Gen Xer, you might want to plan on getting a little bit less or that you’re going to have to wait longer to collect,” says Hammer.

Consider lifestyle and expenses

You also need to take other things into consideration such as whether or not your house will be paid for, whether or not you’ll be an empty nester (uh, we hope you are by then) and if you’ll be moving to a cheaper part of the country.

So, with all that in mind, you take the number you think you are going to need and then start working backwards. If you think you’re going to need $60,000 per year in retirement, that’s $5,000 per month. If you really think you’re going to get about $2,000 per month from Social Security then notch that out and you’re left with $3,000 per month or $36,000 per year that you need to come up with in retirement.

Hammer says while it may not be as accurate, another quick-and-easy rule of thumb to determine how much you’ll need is to multiply your salary by 20 to 25. So if you’re making $40,000 per year, you’ll want to aim to have $800,000 to $1 million put away by the time you retire.

If you’re 30 years old it may seem impossible to save enough money when you’re making $40,000 per year but remember that you may be making twice that 15 years from now.

Use your goal number to discover how much you need to save every month

So, you take that retirement goal number and work backwards. If you want to retire with $800,000 35 years from now, and assume that you’re going to earn a return of 8 percent, you’re going to have to put away roughly $4,400 per year or $366 per month.

Check out some of the calculators at Bankrate.com to help figure out how to best save for your retirement. The good thing is that when it comes to retirement, time can work in your favor. The longer you have to save and let your money grow, the larger your nest egg will become.

Starting at 22 is going to make it a lot easier than starting when you’re 32. The first $100,000 takes the longest to save, and the biggest returns will come in a rush near the end of your working life.

Think about it this way: An 8 percent gain on $50,000 is only $4,000, but an 8 percent gain on $300,000 is $24,000. As your portfolio grows larger, each year’s gains will grow larger as well. Retiring with $1 million is not impossible but it’s a lot easier to do when you start early.

Start saving for retirement as soon as possible

You may have already missed the first seats on the boat but the earlier you save for retirement, the better. This is because by making regular contributions and using the power of compound interest, you can build a bigger nest egg by starting to save small at age 25 than you can by saving lots at age 40.

We know, it sounds lame. When you’re in your twenties you want to have fun. You want to buy cool shit, party till dawn, drive a nice car and shop at the Gap. You don’t want to think about putting away money for when you’re a grandpa or grandma.

Even if you’re doing everything right financially, you still feel like you should be able to blow a wad of cash on the weekends. Go ahead and do so, just understand that someday you’re going to have gray hair, walk with a cane and not feel so sexy anymore. You may also have erectile dysfunction.

The last thing you’ll want at that point in your life is to have to have to live in a cardboard box under the freeway, eat canned beans and eek by on the measly $1,800 Social Security check that the dysfunctional federal government sends you every month.

It doesn’t have to be that way. Many seniors these days live like they’re in their 20s. They run marathons, they party on Bourbon Street, they drive fast cars, they wear bikinis and pick up on young studs. Like it or not you’re going to get old someday and when the time comes, you might as well try to live the good life.

The best way to do that is to start saving NOW. It doesn’t have to be a lot, a little bit is better than nothing. If you’re 25, fresh out of college, have a decent job and can manage to sock away just $150 per month, it can grow to more than a half million by the time you’re 65, assuming you earn a return of 8%. Bump that up to $200 and you’ll have $675,000.

“The earlier you save, the better. Even if it’s your first job and you can only start out with $100 per month do it. It’s about baby steps, taking on step at a time. If people can start saving when they’re in their 20s, it’s going to be so much easier when they get older,” said Kimberly Foss.

Now, if you wait until you’re 40, you’ll have to sock away $550 per month to have a half million by 65. And if you think it’s hard to save now, it could be even harder to save later when you have a mortgage to pay and a couple of kids running around. At that point, putting away $550 a month might not be too easy and you may regret not forking out that measly $150 a month when you were in your 20s.

Think about it. $150 per month to have yourself a half million when you’re 65. That’s not much to ask. Find the money and do it. If you’re already in your thirties or forties and have little saved for retirement then it’s time to start doubling down.

The best part is that once you start saving for retirement, even if it’s only $100 per month, you’ll start having a long term goal and vision of where you’re going. That will lead to you wanting to save more, minimize your debt and make better financial decisions.

“Start saving in increments that are sustainable. It’s about discinpline. Saving for retirement teaches you to be financially accountable for yourself in many other ways, said Foss.