It is never to start soon saving for your retirement. It is a great thing for someone young who has some earned income to save a portion of it in an Individual Retirement Account for their retirement. If a parent wanted to give their child a gift that will give them many times more than just a single occasion, they could provide the funding for the account provided that the child still had earned income. So, what does it mean to save as early as possible for retirement in an IRA? We will examine that and some other aspects of IRAs in this week’s post.
Starting at an Early Age
While the age at which a child can open an IRA varies from state to state, they are eligible to open their own account at the age of 18. But in many states, it is legal for a child to open one at the age at which they start working and have earned income to place in an IRA. If you live in a state where the age is 18 to open your account, it is legal for a parent to open an account for a child at any age, again, provided the child has earned income.
So, what is the difference between two children that open IRAs with a thousand dollars and then make no more contributions or make any withdrawals until they reach their full retirement age of 67? Well, the results may surprise you a little considering the difference is only two years. In this example, that initial $1,000 will grow at 8% annually until age 67, meaning that an 18-year-old will end with $43,427. And the account for a 16-year-old who earns the same 8% annually, but for an extra two years, is worth $50,654 or an extra $7,227. Now that is worth opening an account two years sooner in my opinion.
Rates of Return
Now, most people know that as you approach retirement, you should shift your asset allocation from one that is heavy on equities to one more geared towards income production. That means when you are younger, you can afford to take additional risks that someone approaching retirement cannot afford to take. This is because a younger person has more time to make up for a period of poor performance by their investments. In an age where people are living longer and therefore are requiring more funds due to being retired longer, everyone needs to stay in equities to a degree. But what that degree is will be different for everyone as some people are comfortable taking more risks than others. But regardless, the key takeaway here is to properly prepare for your retirement before reaching your full retirement age.
So, in the following chart, we are looking at three 18-year-old individuals who invest $6,000 annually for 49 years. What is different is the return on their investments over these 49 years. As you can see in the graph, the individual who earns a consistent 8% retires with the most but not by all that much over the next individual. The second individual earns slightly less due to the fact they earned 4% for the first five years then 8% for the remaining 44 years. The earnings for this slight difference are only about $124,659. But what is surprising is the individual who earns 8% for the first 44 years and then 4% for the remaining five. They earn $589,694 less than the constant return of 8% and $465,305 less than the individual who earned 4% over the first five years. The takeaway from this is the timing of poor returns can have a dramatic impact on your overall portfolio’s balance.
ROTH Conversions
With the rules have changed in the previous years on ROTH conversions, they still make sense provided you are 100% certain that is what you want to do with some of your Traditional IRA. Several years ago, the government changed the law to make any ROTH conversions permanent were prior to this change, and there was a brief period where you could change your mind and convert the IRA back. So, if you make this conversion be sure that is what you want and can afford. Also, conversions, unlike contributions, must be made in the year that they are converted and not by April 15th of the following year.
When is a good time to make a ROTH conversion? While circumstances are different for everyone, these are some general guidelines that you may wish to follow. As you will be paying taxes on the proceeds of the Traditional IRA that are being converted to a ROTH, the end of the year is an excellent time of the year to make the conversion. The reason behind this is you will have a better idea of what your taxable income will be and what tax bracket you will be converting the funds within. And with the passage of the new tax law, you should, in theory, be in a lower tax bracket meaning you will pay fewer taxes on the conversion. And unlike a Traditional IRA, there are no Required Minimum Distributions required for a ROTH IRA that are mandatory now at age 72 for Traditional IRAs.
IRAs are an excellent tool to aid anyone in their retirement goals. And as I have shown in this post, the sooner one starts saving in an IRA the better off they will be at their full retirement age. And as you can also see, it is better to have consistent returns on your funds rather than trying to time the markets and play it safe early or trying to be too aggressive later in the process. The key to any successful investing is to understand what it is you are investing in, the risks associated with the investment and what the proper asset allocation is for achieving your long-term goals.
If you have any questions or need any assistance feel free to contact me or seek out the assistance of a fee-only Registered Financial Consultant. And to receive our email newsletter, please fill out the form below.
