By Liberty McAteer
I'm 18 years old. I'm different. I have an IRA. Right now my Roth IRA is worth $22,000. If I never make another contribution, it will be worth $819,000, tax-free, when I'm 65. That assumes a reasonable 8% annual return on my investments. If I put in the maximum allowed every year, I'll have $2.8 million when I'm ready to retire. Cool.
Almost any kid can have an IRA, and kids should open them as early as they can. The most important deposits are the first ones. The $22,000 I have in my IRA now will be worth more than the compounded value of the $5,000 a year I put in between the time I'm 31 and 64.
I got lucky. When I was 10 years old, I was cast in a television commercial for Kraft Foods' Flintstones macaroni and cheese -- I played a caveboy. Over the commercial's two-year run I earned about $10,000. My mother opened an IRA for me at a brokerage firm, and I made my first contribution in 1994. I invested the whole $2,000 in Marvel Entertainment because I liked the company's comic books. I lost the whole investment.
Since then, my mother has handled my investments, but we always talk about what to buy, especially when tech stocks are involved. We've bought and sold Merck, Hanson, Newport, eBay and Amazon.com a few times and always made a profit -- except in Amazon, which we sold at breakeven after a wild ride. We do not buy and hold. We are "drive by" investors, which has worked out well, making 9% a year, despite my Marvel Comics debacle and the recession.
At the moment, I have some Intel, Hanson, Newport and a small company called Rentech. But mostly I have cash.
Four years ago, after Congress created the Roth IRA, I converted my regular IRA to a Roth. Since I converted it that first year, I was able to pay the $1,168 I owed in taxes in four annual installments. I'll make the last $292 tax payment this year. Paying those taxes now will probably be one of my best investments, because I'll never have to pay taxes on the money again. That's the main difference between a traditional IRA and a Roth. With a traditional IRA, your contributions are tax deductible -- when you're at my income level, that is -- but the money is taxed when you withdraw it. With a Roth, the money is taxed before you contribute it but it's never taxed again, no matter how much it grows.
There's no minimum age for opening an IRA, so any kid can do it, as long as he or she has earned income. That means the child has to earn the money himself from jobs like baby-sitting, delivering newspapers and mowing lawns; income from bonds that Grandpa bought or interest on a saving account isn't applicable. The only hitch is that you'll have to report the money to the Internal Revenue Service for it to qualify, and that means you'll have to pay 15.3% in Social Security and Medicare taxes on your earnings.
Even so, it's probably worth it, especially if your parents pay the taxes and make the actual contributions for you. My first two IRA contributions were made with the money from my commercial. Since then, my mother has let me keep the money I've earned, and she makes the contribution for me, which is completely legal. But now that I'm 18, I'm worried that since I have been telling her I'm grown up, she'll make me start putting in the money myself.
When I was 14 my mother asked me to sort through a decade's worth of files she had accumulated working as a consultant to a science foundation. She paid me $8 an hour to print out her files, alphabetize and label them, throw away duplicates, and generally get everything organized and updated according to her instructions. Working on and off for a couple of months, it took me about 60 hours. I kept careful records for the IRS.
That year I also got a little bit of computer-programming work through a friend of my father for $10 an hour, but I was able to make only a $700 contribution to my IRA. That's okay, because there's no minimum amount that you have to put in; any money a child earns qualifies. The most important thing is that all income is documented, and you cannot claim that you're earning an unreasonable amount, especially when you're working for your Mom or Dad. Minors' tax returns have just the same chance of being audited as anyone else's, so when my mother hired me to work as her file clerk she did not pay me $50 an hour; she paid me the going rate for file clerks.
The following year I worked for my grandmother. She's retired now, but she used to have a business that sold bathing suits and prosthetics to women who had had mastectomies. I built a Website for my grandmother's company, and she paid me $30 an hour for my work. That's a lot less than a grown-up Web programmer would have made, although the site I did for her was as good as any adult would have done. She also paid me to maintain the site for the next few years and so I got to make some more IRA contributions.
And the summer I turned 16, I worked as an intern for Plural, a Website company on Wall Street that paid me $12 an hour -- $4,300 for the whole summer. At the time Plural had 550 employees; a year later it had fewer than 200, thanks to the Internet nosedive. Many of the people who lost their jobs also lost Plural's contribution to their 401(k) plans because they hadn't been with the company long enough for the company's matching money to become vested. But my IRA contribution is safe and sound in my Roth.
Last year, new legislation was signed raising the maximum annual contribution to $3,000 this year, $4,000 in 2005 and $5,000 in 2008. If I had waited until 2008, when I'm 24, to start contributing to my IRA -- and contributed the max -- it would grow to $1.3 million by the time I'm 65, assuming an 8% annual return. Not bad. But with what I've got now, plus the maximum contributions every year from here on out, it will be worth twice that.
One last thing to keep in mind. If you're under 18, one of your parents will have to be named as the custodian for the account. And no matter how old you are, you'll have to name a beneficiary for the account in the event that you die before you start making withdrawals. I put down my 80-year-old grandfather. I couldn't name my mother beneficiary because she's the custodian of the account. So while millions of kids are the beneficiaries of their grandparents' IRAs, my grandfather is the beneficiary of mine. If he lives another 40 years and I die first, he'll be really rich
Liberty McAteer is a high-school senior. He lives in New York City.
Americans have a hard enough time saving for retirement.
Then there's the next challenge: Figuring out where to
put that retirement money.
A mind-boggling array of tax-advantaged retirement plans has sprouted in recent
years, with each plan carrying its own rules and limitations. Trying to swim
through the alphanumeric soup of IRAs, 401(k)s, 403(b)s and such can make it
tough to see which plan is best for you.
"Some people are not putting their money where they should be," says Laurence
Kotlikoff, an economics professor at Boston University, adding that confusing
rules exacerbate the problem. "There's no way around it. You really have to run
the numbers for your particular situation." Many workers fund tax-deferred plans
like 401(k)s and deductible individual retirement accounts even when they should
start a Roth IRA, he says, because a Roth offers tax-free withdrawals.
Next year, the choices will become even more jumbled. Starting Jan. 1, companies
can offer a Roth version of the 401(k). Although the rules are still taking
shape, the Roth 401(k) is expected to be similar to the standard 401(k) but with
tax characteristics of a Roth IRA. This could be a welcome option for the many
workers who are already familiar with the Roth IRA's tax-free earnings. About
one-third of employers are likely to offer the Roth 401(k) right away, according
to Hewitt Associates, a Lincolnshire, Ill., consulting firm, and many more are
expected to offer them by the end of 2006.
Still, with so many options, how do you pick the best retirement strategy for
your own situation? Here are the major considerations.
PAY TAXES NOW, OR LATER?
A critical question is whether you prefer to receive a break on your taxes now
or when you retire.
For those who qualify, Roth-type plans provide no tax break on current income,
but a potentially big break later: Once participants have held the Roth for five
years and have reached the age of 59½, all withdrawals are income-tax free. So,
the better your investment performs, the bigger the tax savings.
By contrast, traditional IRAs and 401(k)s let qualified participants reduce
their taxable income by amounts equal to their contributions. But their
withdrawals are taxed as ordinary income.
For most people, the Roth's tax benefits will trump those of a traditional plan,
financial planners say. Only in very specific circumstances will you come out
ahead with a traditional plan. One such case is when an earner projects that his
or her tax rate will fall in retirement; in that case, it's more important for
the earner to get a tax break now. Someone who plans to keep money in the plan
for a short time -- such as five or 10 years -- also may want to stick with the
tax-deferring benefits of a egular IRA or 401(k) for the same reason: The
immediate benefits of the tax deduction outweigh the prospect of tax-free
earnings over a short period.
Once you've decided your tax preference, consider the qualifications that have
to be met for each kind of plan. If your income is above certain limits and you
have a retirement plan at work, you won't qualify for the tax deduction that
traditional IRAs offer. In that case, investing in a regular IRA usually isn't
worth it, says John Nersesian, a wealth-management strategist for Nuveen
Investments in Chicago. For singles, the tax deduction starts to get phased out
at adjusted gross income of $50,000, and is phased out completely at $60,000;
married couples can't deduct anything if they have adjusted income of more than
$80,000.
Nor is everyone eligible for a Roth IRA. Individuals are barred if their
adjusted gross income exceeds $110,000 in 2005; married couples are barred if
their joint adjusted income is more than $160,000. But if your income is within
these limits, a Roth generally makes most sense when you expect the money to sit
in the account for many years -- allowing ample time for it to compound
tax-free. Roth plans are also preferable for those who aren't sure they'll need
to use their retirement money. Roth owners and their spouses don't have to tap
into their IRAs during their lifetime; traditional IRA owners must start taking
required minimum distributions soon after turning age 70 1/2.
Young or old, Roth plans are good if you want to hedge against future tax
increases. Workers near the beginning of their careers may also benefit from a
Roth if they figure they are likely to be in a higher tax bracket when they
start taking distributions.
Tax increases are likely, given today's record federal deficit, budget
shortfalls and relatively low tax rates, says Dallas Salisbury, president of the
Employee Benefit Research Institute, a nonpartisan organization in Washington.
"I think the benefit of the Roth is dramatically underplayed," Mr. Salisbury
says. People typically think, "How is this going to benefit me this year, right
now?" he says. It's harder to sell people on the idea of future tax benefits.
Several online calculators, such as the Roth vs. Traditional IRA calculator at
Dinkytown.net, a Minneapolis-based Web site of financial tools, can help compare
how your money would build up in a Roth IRA compared with a regular IRA. You
answer questions such as current tax rate, expected future tax rate, age and
expected yearly contributions. Whether you choose a Roth or a traditional IRA,
the contribution limits for 2005 are $4,000 per individual, or $4,500 for those
50 or older by year end. The calculator then shows you how much you'd have saved
up in each type of account by retirement.
One drawback to these online calculators is they make you project your future
tax rate, which tends to be an unknown. But then no one's crystal ball is
perfect.
401(K), OR IRA?
If your employer offers a 401(k), should you make that your retirement plan, or
should you stick with an IRA?
Maybe you can do both.
The Roth 401(k) is likely to be the best option for many workers when it becomes
available next year, says Lori Lucas, defined-benefit consultant for Hewitt
Associates. The Roth 401(k) will let workers invest after-tax earnings with the
promise of tax-free withdrawals. The government could still tinker with the
rules, but as it stands there will be no income limitations on who qualifies.
Many other facets of the Roth 401(k) will probably be the same as for regular
401(k)s, including the contribution ceilings. This year, workers can contribute
up to $14,000 a year, with a $4,000 annual "catch-up" contribution available for
those 50 and over by year end. Whether Roth 401(k)s will match contributions is
up to the employer.
What should you do in the meantime, until the Roth 401(k) becomes an option?
First, a good rule of thumb is to never pass up an employer's offer to match
contributions to a 401(k). Whether the match is limited to 2%, 5%, or 10% of
your salary, it's essentially free money and usually trumps any other
consideration, says Mr. Nersesian. A 401(k) carries no restrictions on how high
your income can be.
People working for a government, public school or nonprofit may have 403(b) or
457 plans instead of a 401(k). These have the same pretax contribution limits as
a 401(k), a catch-up contribution for those 50 and older, and often an employer
match. A Roth version of the 403(b) will also be available starting next year.
After you've maximized the full employer match in your employer-sponsored plan,
your next best option might be to fund a Roth IRA, provided you qualify, and
once you reach that limit, go back to the 401(k).
A Roth IRA will almost always churn out more money than a traditional 401(k),
because the Roth's tax-free earnings will usually beat the tax-deduction savings
of the standard 401(k) over the long haul.
There are some disadvantages to 401(k)s. The number of investment options in
each plan typically is relatively small -- an average of 17 per plan in 2003, up
from 10 in 1998, according to the Chicago-based Profit Sharing/401(k) Council of
America. What options there are usually include relatively safe investments such
as index mutual funds or life-cycle funds, which feature a changing mix of
equities and fixed-income instruments targeted to an expected retirement date. A
typical 401(k) might offer a small-cap or midcap fund and a bond fund. Many
people can build a diverse portfolio just using those limited investments.
However, more risk-tolerant or ambitious investors might prefer the greater
flexibility of an IRA. IRAs typically let you invest in individual stocks and an
array of mutual funds and riskier investments such as emerging-market funds and
real-estate investment trusts that you may not find in an employer plan.
But along with that flexibility may come greater investment costs. Many 401(k)s
charge little or no commission when you buy or sell, Mr. Salisbury says, but
IRAs commonly charge standard brokerage fees such as $30 each time you buy or
sell an asset. That adds up if you rebalance your portfolio regularly or like to
swap investments. Also, employers may negotiate lower expenses on their funds
than brokerage accounts offer, he says.
So, compare fees and transaction costs before picking a plan.
SMALL-BUSINESS OPTIONS
Self-employed and small-business workers have different choices for retirement
investing.
Many small businesses don't offer 401(k)s, but instead use either Simplified
Employee Pension IRAs or Simple IRAs. A SEP IRA lets the employer contribute as
much as $42,000 a year, up to a maximum 25% of compensation, to a tax-deferred
IRA on an employee's behalf. The employer makes all of the contributions to
these kinds of accounts, though the workers can also contribute to their own
Roth and deductible IRAs.
Businesses with fewer than 100 employees might use Simple IRAs. These
tax-deferred plans let employees contribute a maximum of $10,000 this year -- up
to a maximum 100% of compensation -- and $2,000 more if age 50 or older.
Small-business workers can also contribute to Roth and deductible IRAs, but if
an employer match is offered in the work plan, maximizing the employer match
should come first, says Ed Slott, a certified public accountant and IRA expert
in Rockville Centre, N.Y.
Business owners looking to save more than $42,000 annually may opt for what's
called a defined-benefit Keogh plan. Traditional Keogh plans have fallen out of
favor due to the rise of SEP and Simple IRAs, since Keoghs often involve intense
record keeping. But defined-benefit Keogh plans work like pensions and can be
the right choice for those who can afford to stash away more then $42,000 pretax
each year, Mr. Slott says. They can, however, be costly to administer because
they require an actuary to oversee the plan.
Keoghs let the employer (that would be you) contribute up to $170,000 a year, or
a maximum 100% of the average compensation of the employee (you, again) over
three consecutive years. However, flexibility is limited because your annual
contribution is based on IRS formulas and actuarial models and depends on
income, the target benefit, years until retirement and expected investment
returns. Also, other employees at the business must receive contributions in
their accounts, too.
These plans are usually best for older workers who earn a big salary and have
only a few employees working for them.
OTHER THINGS TO CONSIDER
People who like the idea of a fixed income in retirement might want to set aside
money in a tax-deferred annuity, which provides a break on your current taxes
and promises to pay out a monthly fixed income when you retire. However,
annuities have come under scrutiny in recent years for hidden fees and little
investor control, says Nuveen's Mr. Nersesian. So it's important to read over
the terms very carefully before committing to one.
Also consider flexibility. If you think you might need to withdraw money from
your retirement plan before you reach the minimum age for penalty-free
distributions, you might choose your company's 401(k) since these plans usually
let you take out a loan of as much as 50% of your account's balance, to a
maximum of $50,000. They also let you take out hardship withdrawals if you
become disabled or rack up huge medical bills. A Roth lets you withdraw an
amount equal to your contributions, with no penalty, at any time.
Sorting out the various retirement-plan options
ROTH 401(K)*
TYPE: Employer-sponsored, after-tax savings plan
KEY ADVANTAGES: Tax-free earnings, potential employer match on contributions
KEY DRAWBACK: Limited investment options
GENERALLY BEST FOR: Almost everyone eligible, at least up to the maximum
employer match
401(K)
TYPE: Employer-sponsored, tax-deferred plan
KEY ADVANTAGES: Employer match on contributions, tax-deferred growth
KEY DRAWBACK: Limited investment options
GENERALLY BEST FOR: Employees without access to a Roth 401(k), at least up to
the maximum employer match
ROTH IRA
TYPE: Individual retirement account, after-tax savings plan
KEY ADVANTAGES: Tax-free earnings, many investment choices, flexible
distributions
KEY DRAWBACKS: Potentially higher costs than employer plans; income limits on
eligibility
GENERALLY BEST FOR: Anybody who doesn't have a Roth option at work or those
seeking more investment choices after maxing out on their employer match
TRADITIONAL IRA
TYPE: Individual retirement account, tax-deferred savings for those who qualify
KEY ADVANTAGE: Tax deduction on contributions for those who don't have a
retirement plan at work or whose incomes are below certain limits
KEY DRAWBACKS: No tax-free earnings, low income limits on eligibility for
deductions
GENERALLY BEST FOR: Those without any other retirement plan or who want
tax-deferred savings and qualify for tax deduction
SIMPLE IRA
TYPE: Tax-deferred retirement plan for small businesses with fewer than 100
employees
KEY ADVANTAGES: High contribution limits ($10,000 a year, higher if you're over
age 50), employer match on contributions
KEY DRAWBACK: No tax-free earnings
GENERALLY BEST FOR: Small-business employees
SIMPLIFIED EMPLOYEE PENSION IRA
TYPE: Tax-deferred plan for self-employed workers
KEY ADVANTAGE: Employer defers up to $42,000 annually, to a maximum 25% of
compensation
KEY DRAWBACK: No tax-free earnings
GENERALLY BEST FOR: Self-employed workers
DEFINED-BENEFIT KEOGH PLAN
TYPE: Employer-funded pension plan for small businesses
KEY ADVANTAGE: High employer contribution limit (up to $170,000 a year)
KEY DRAWBACKS: Complicated rules and record keeping; expensive to administer
GENERALLY BEST FOR: Self-employed workers looking to save large amounts