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According to a 2018 survey from Provision Living, 43% of millennials have less than $5,000 saved for retirement.
Since one financial benchmark says that you should aim to save 1x your annual salary by age 30, most are well behind where they should be in saving for retirement. It is clear that the record high cost of attaining a college education is taking its toll on the economic prospects of millennials.
The blindingly high tuition costs mean that new graduates are focused on paying off student loans instead of saving for retirement. Knowing if you should refinance your student loans may help, but that won’t be enough. The fact that younger Americans are less likely to out-earn their parents, only complicates matters more.
While under-saving for retirement is an issue, having enough saved in case of an emergency should be a more pressing concern.
Conventional wisdom says that you should set aside at least three months of living expenses. Therefore, if the average millennial earns $21.80 per hour, or roughly $43,500 per year, they’d need to save $5,438 to cover three months of living expenses, assuming they can live off of 50% of their income. If they live off of 75% of their income, the figure increases to $8,157.
If you unexpectedly lose your job or incur an emergency medical expense, you’ll want your emergency money, referred to as an emergency fund, to be readily accessible. This generally means parking your money in a savings account. However, there’s a strong argument to be made that part of that money should be saved in a Roth IRA.
The Roth IRA has been around for years, but young Americans need to give it a second look. It might just be the spark they need to boost their retirement savings. You might be wondering “what is an IRA?”, so let’s get on the same page.
A Roth IRA is a tax-advantaged retirement account, in which after-tax dollars can be saved for retirement and ultimately withdrawn free of additional taxes.
One of the most overlooked and unique benefits of the Roth IRA is the fact that your contributions can be withdrawn at any time, for any reason, penalty-free and tax-free. The same does not apply to your investment gains. Or to Traditional IRA contributions.
The 2018 contribution limit for a Roth IRA is $5,500 and is increasing to $6,000 for the 2019 tax year. If you are 50 years old or older, you can contribute an additional $1,000 annually in catch-up contributions.
A Traditional IRA differs from a Roth IRA, in part, due to the timing of the tax benefit. A Traditional IRA gives you tax savings upfront, while a Roth IRA defers the savings until your retirement. A Roth IRA may be ideal for young individuals in lower tax brackets, so they can minimize their lifetime tax bill. This is because you’d be better off paying taxes in years in which you are in lower tax brackets than when you are in your peak earning years.
For this reason, the 2018 tax cuts may make a Roth IRA more appealing to a broader set of individuals.
While the annual salary contribution limit means that not everyone can contribute to a Roth IRA, the majority of individuals are eligible. For 2018, the income thresholds for Roth IRA participation phaseouts are $120,000 for individuals and $189,000 for married couples filing jointly.
While a Roth IRA is not as liquid as cash or a savings account, it might be the perfect place to save a portion of your emergency fund. You want your money to be readily available in case of an emergency, so parking your entire emergency fund there probably isn’t wise. But leaving it entirely in a bank account earning just pennies in interest might not be your best bet either.
Remember that the Roth IRA contributions can be withdrawn without any fees or taxes at any time. Fidelity, a major custodian of IRA accounts, says that it takes them three to five days from the day you request a withdrawal to get you a check with your money.
On top of the liquidity issue, there’s also the fact that you’ll be exposing your money to potential investment losses. The last thing you want during an emergency is to realize that you have less money than you invested. This is always a risk when investing money, and it should be considered carefully when deciding how much to invest.
You also want to avoid letting a decade go by and realizing that you only made $50 in interest on your $5,000 balance over that period. Instead, you can invest your money in a low-cost index fund, earning a conservative annual return of 3%, which would net you over $1,700 in earnings. A meaningful amount for money that may not be needed anyway.
Ideally, you won’t touch your Roth IRA contributions until retirement, since the power of compound interest is most effective over a longer period of time. Here’s an overview of what compound interest is.
But while drawing down on your IRA early is less than ideal, it’s foolish to go into credit card debt to cover an emergency expense, since those interest rates can easily range from 15% to 25%. With rates that high, a seemingly small credit card balance can quickly balloon and cripple your finances.
A Roth IRA isn’t a substitute for a high yield savings account, but it’s the perfect complement to your savings strategy. The sooner you start, the better.
