Why Everyone Should Open A Roth IRA Soon After College

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Includes: IJR, IWM, SCHA, SCHX, SPY, VB, VTI
by: Daniel Ward

Summary

Broad, market-tracking ETFs are a great way to manage a Roth IRA in a simple, cost-effective way.

Utilizing ETFs tracking the small-cap universe can provide you with a bit higher annualized return and a significantly bigger Roth IRA by retirement.

The power of compounding makes it very important that college grads start their Roth IRAs early.

With the recent pullback in the equity markets this month, now seemed like a great time to write about why everyone should consider getting setup with an IRA right after graduating college and settling down in your first post-grad job.

What is a Roth IRA?

-A Roth IRA is an individual retirement account that allows your money to grow tax-free after your contribution.

-For a more detailed explanation, click here

Why is the Roth IRA better for young people compared to the traditional IRA?

-Contributions to traditional IRAs are tax deductible, but withdrawals at retirement are taxed at the rate of ordinary income. Roth IRAs have no tax benefits at the time of the contribution, but withdrawals at the time of retirement all take place tax-free. With the assumption that your tax rate will be higher at retirement as opposed to now, especially considering the likelihood that tax rates will rise in next 40+ years give the size of the national deficit, it makes much more sense to pay the tax right off (with the Roth IRA) as opposed to when you are withdrawing the funds at retirement (with the traditional IRA)

-For more on the differences between a traditional IRA and a Roth IRA, click here.

How can I open a Roth IRA, and how should I invest it?

Opening up a Roth IRA is very simple, as most brokerages will only require your social security number, your driver's license number, your employer's name and address, and your beneficiary's contact info. You can connect your Roth IRA to an external bank account so you can make contributions electronically at no cost via ACH (Automated Clearing House) transfers.

You will see many recommendations in regards to how to invest your Roth IRA. My first advice is to avoid transaction fees (especially if you are contributing monthly) as well as avoid funds with higher expense ratios, as both of these costs will significantly cut into your gains from compounding. A large number of discount brokers do have options for avoiding commissions, with Schwab, E-Trade, TD Ameritrade, and Fidelity all having a number of ETFs that are commission-free. Many in the industry also have no transaction fee mutual funds available for customers. Finding funds with a low expense ratio can be a bit more difficult. To do this, it is typically best to stick with ETFs sponsored by companies that are known to have very low expense ratios on their funds, including Vanguard, Schwab, and iShares. It should be very easy to find funds to use with an expense ratio of 0.2% or less and you certainly want to be paying 0.5% or less for a fund in your IRA. Funds can have expense ratios, with two, three, or even four percent being possible. One astute Seeking Alpha writer even noticed a fund with an expense ratio over 8%!

The simplest way to invest your Roth IRA would be a broad ETF that follows the market:

Name

Ticker

Expense Ratio

What does it aim to track?

SPDR S&P 500 ETF

(NYSEARCA:SPY)

0.09

S&P 500

Vanguard Total Stock Market ETF

(NYSEARCA:VTI)

0.05

The entire US stock market

Schwab US Large Cap ETF

(NYSEARCA:SCHX)

0.04

750 of the largest US companies, making up approximately 85% of the US stock market

For young people just starting out, it may be smart to look to invest your Roth IRA in small cap stocks as studies have shown that small cap stocks have higher returns (some studies even have showed small cap stocks having higher returns on a risk-adjusted basis). Below are some low cost small cap ETFs to consider:

Name

Ticker

Expense Ratio

What does it aim to track?

iShares Russell 2000 ETF

(NYSEARCA:IWM)

0.2

Russell 2000

iShares Core S&P Small-Cap ETF

(NYSEARCA:IJR)

0.14

S&P Small Cap 600 Index

Vanguard Small Cap ETF

(NYSEARCA:VB)

0.09

MSCI US Small Cap 1750 Index

Schwab U.S. Small Cap ETF

(NYSEARCA:SCHA)

0.08

Dow Jones US Small Cap Total Small Cap Market Index

While I do want to note that small caps have underperformed the market this year, Roth IRAs have a very long time frame and small caps have been shown to handily outperform their large cap counterparts over the long term. Looking at an example of a 20-year-old contributing $1,200 a year to a Roth IRA until retirement at 65, let's compare putting the contributions in a broad, market-tracking fund using the 7% annualized return versus a small cap fund using an 8% annualized return.

Starting Age

Invested In

Annual Contribution

Retirement Age

Projected Value at Retirement

20

Small cap fund

$1,200

65

$500,911

20

Broad, market-tracking fund

$1,200

65

$366,903

By investing in the small cap fund as opposed the broad, market-tracking fund, the Roth IRA is 36.5% bigger at retirement just due to the annualized percent gain of the small cap fund being one percent greater.

The Power of Compounding:

An important point I want to pitch in regards to getting a Roth IRA right out of college is the power of compounding. Compounding in layman's terms means that your earnings generate more earnings for you, which is often described as the snowball effect. See the below illustration of compounding looking at the growth of $1,000 over two years where a 10% gains is seen in each year:

 

Beginning Value

% Gain

$ Gain

$ Gain (From compounding)

Ending Value

Year 1

$1,000

10%

$100

$0

$1,100

Year 2

$1,100

10%

$110

$10

$1,210

In year 1, the 10% gain on the $1,000 beginning value leads to a $100 gain. We begin to see the beauty of compounding in year 2 though, when the 10% gain on the new beginning value of $1,100 provides a total gain for the year of $110. $10 of this gain is the 10% gain in year 2 made on the $100 in profit from year 1.

To further understand the power of compounding and the importance of starting a Roth IRA early, let's compare how much a 20-year-old contributing $1,200 a year until the age of 65 would earn versus a 30-year-old contributing $1,200 a year until the same age. For simplicity's sake, let's assume the funds are invested in a broad, low-cost stock fund earning 7% a year, which even per Warren Buffett is a reasonable amount to expect to earn in the market.

Starting Age

Annual Contribution

Retirement Age

Projected Value at Retirement

20

$1,200

65

$366,902

30

$1,200

65

$177,496

By starting to contribute at the age of 20 instead of waiting to the age of 30, thanks to the power of compounding, your Roth IRA is more than twice the size due to your early contributions. The difference is even more pronounced on a dollar value basis if you look at the numbers if you were to contribute the maximum amount of $5,500 to your Roth IRA every year.

Starting Age

Annual Contribution

Retirement Age

Projected Value at Retirement

20

$5,500

65

$1,681,635

30

$5,500

65

$813,524

Waiting for ten years before your initial annual contribution of the $5,500 maximum leads to your Roth IRA being worth over $800,000 less than if you had started contributing at 20.

Can I do this while paying off loans?

Paying off loans is very important and definitely a priority. Regardless, it is definitely reasonable to contribute to a Roth IRA even while paying off loans. Even if you are only able to contribute $300 a year (an average of $25 a month) to a Roth IRA while you are paying off loans, that was still allow you to take advantage of the power of compounding.

Summary:

Right after college is a great time for recent grads to sent up a Roth IRA. Putting contributions into a low-cost, broad, market-tracking ETF or small cap ETF provides an easy way to manage your Roth IRA. Due to the numerous tax benefits of a Roth IRA as well as the power of compounding, setting up a Roth IRA early is a big key to steadily establishing a significant retirement.

Disclosure: All projections in this article are based on historical returns and assumptions. Past performance of any stock or group of stocks is not necessarily indicative of future returns.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.