Why Your College Student Should Have A Roth IRA
There are so many financial advantages that students can gain by utilizing a ROTH IRA while still in school. Typically, ROTH IRAs are used for retirement savings, and while they should still do this at such a young age, college students can use it for college savings!
With a ROTH IRA, college students are able to invest in all the usual investing instruments such as stocks, bonds, mutual funds, options, money market funds, etc. Unlike other retirement plans, Roth IRAs are straightforward with taxes, using post-tax dollars. This makes them an excellent tool for low earning college students.
What is a Roth IRA and How Does It Work?
A Roth IRA is an individual retirement account that doesn’t take out any tax on your gains (profit) that you make through your investments. Despite how great that sounds, there is a set rules for ROTH IRAs.
Contributions
Contributions are deposits (the money) that you put into your ROTH IRA account. With a ROTH IRA, there are a set of rules that come with contributions.
Contribution Rules:
Contribution Limits: With a ROTH IRA, you can only deposit a certain amount each year (this changes yearly). In 2023, the contribution limit is $6,500 for anyone 49 and under and $7,500 for anyone over 50 years old.
Qualified Contributions: With a ROTH IRA, you can only contribute income that you earned. That means money earned from jobs/freelance that will be reported for your taxes. For example, if you work a W-2 job and earn $6,500 or more. You are okay! But if you earn $2,000 for the year, you can only contribute that much. Summing it up, you can only put earned taxable income in and you can’t put money in that is received from gifts or income earned by a parent.
Income Limit: With a ROTH IRA, you can only contribute to one if you make less than $153,000 if you file your taxes as a single person, or $228,000 if you file your taxes as married.
Withdrawals
Withdrawals are when you take money out of your ROTH IRA. Just like deposits, withdrawals come with a set of rules too.
Withdrawal Rules:
Tax-Free Withdrawals: Roth IRAs allow you to withdraw your earnings/profit tax-free, but there are conditions. The account must be open for at least five years, and you must be over 59 1/2 years old. If you withdraw your earnings before meeting these requirements, the amount will be considered taxable income for that year. Additionally, unless an exception applies, a 10% early withdrawal penalty will occur.
Withdrawal Exceptions: One of the unique benefits of a Roth IRA is that you can withdraw your contributions (but not your earnings) at any time, for any reason, without taxes or penalties. This is because you’ve already paid taxes on the money you contributed.
– If you withdraw money and intend to redeposit it into the Roth IRA, you have 60 days from the withdrawal date to do so. Failing to redeposit within this timeframe will treat the amount as a new contribution for the year.
There are also scenarios in which you can withdraw the earnings without the 10% early withdrawal penalty, though you’ll still be taxed normally:
– College Expenses: For you, your spouse, or the children or grandchildren of you or your spouse.
– First-Time Home Purchase: Up to $10,000.
– Disability: If you become permanently and totally disabled.
– Birth or Adoption: You can withdraw up to $5,000 for expenses related to the birth or adoption of a child within one year of the event.
– Medical and Health Insurance Reasons: Unreimbursed medical expenses that are more than 7.5% of your adjusted gross income, or if you’re unemployed, you can use it to pay for health insurance.
Always consult with a financial or tax professional before making any withdrawals to ensure you understand the implications fully.
The Power of Starting Your ROTH IRA Early: Compound Interest & College Students
What is Compound Interest?
One often overlooked advantage of starting a Roth IRA in college is the magic of compound interest. Compound interest is essentially “interest on interest”, and it can make a significant difference in how much a student can accumulate by the time they’re ready to retire. Here’s how it works: when you earn interest on your investments and then reinvest that interest, you earn interest not just on your initial contributions but also on the accumulated interest from previous periods.
Let’s consider a simple example: if a 20-year-old college student starts contributing $1,000 annually to a Roth IRA and continues this practice until they’re 60, with an average annual return of 7%, they’d accumulate over $320,000 by the time they retire. But what’s astonishing is that more than two-thirds of that amount is purely from compound interest.
Starting a Roth IRA in college, even with smaller contributions, allows students to take full advantage of compound interest over a longer period. The more time money has to grow, the more impactful compound interest becomes. Hence, the earlier a student starts, the more they can capitalize on this exponential growth, even if they can’t max out their contributions immediately.
Plus, they get to reap all the benefits of having that ROTH IRA. An adult who is 50, has a house already, and paid for college won’t get access to those benefits of a ROTH IRA like being able to use IRA gains for paying down tuition.
Conclusion
A Roth IRA isn’t just a retirement savings tool; it’s an important financial tool that can change your life.
For college students, starting early can pave the foundation for a smart retirement savings plan. While also offering some short term financial benefits. Embracing the benefits of Roth IRAs during the college years not only sets students up for long-term success but teaches them the invaluable lesson of proactive financial planning.
Whether it’s for college expenses, a first home, or retirement, the Roth IRA is a game-changer. So, if you’re a college student or know one, remember: It’s never too early to start thinking about your financial future. The power of compound interest is waiting for you!
What is a ROTH IRA?
A Roth IRA is an individual retirement account that allows for post-tax contributions, and the gains (profit) from investments are not taxed upon withdrawal, given certain conditions are met.
Why should college students consider starting a ROTH IRA?
Starting a Roth IRA in college allows students to benefit from the power of compound interest over a longer period, leading to significant accumulation by retirement. Additionally, it provides tax advantages and flexibility for some short-term financial needs like college expenses.
How much can a college student contribute to a Roth IRA in 2023?
In 2023, individuals 49 and under can contribute up to $6,500, while those over 50 can contribute up to $7,500.
Can a student contribute gift money or parental income to a Roth IRA?
No, only earned taxable income can be contributed to a Roth IRA. Money from gifts or income earned by a parent is not eligible for contribution.
When can a student withdraw from their Roth IRA without penalties?
Contributions can be withdrawn at any time without penalties. For earnings, the account must be open for at least five years and the individual must be over 59 1/2 years old to avoid taxes and penalties. However, there are exceptions for specific situations like college expenses and first-time home purchase.
Can a college student use Roth IRA gains to pay for tuition or student loans?
Yes, college expenses for the account holder, their spouse, or their children/grandchildren can be an exception to withdraw earnings without the 10% early withdrawal penalty. Taxes may still apply.
How do Roth IRAs offer tax benefits for students?
Roth IRAs use post-tax dollars, meaning contributions are made with money already taxed. This ensures that withdrawals (under the right conditions) are tax-free, making it advantageous especially for low earning college students who currently fall into a lower tax bracket.
