College Student’s Guide to Roth IRAs

by Broke Grad on October 9, 2008

Midterms, finals, homework, quizzes, parties, formals, tailgates, and football games. With all of that stuff on a typical college student’s mind, saving for retirement usually isn’t a top priority. This is really unfortunate because younger people benefit the most from compound returns. When it comes to saving for retirement, time is on your side.

It doesn’t help that retirement funds aren’t exactly the most exciting things in the world, and a lot of articles make them sound more complicated than they really are. I’ve always appreciated teachers who could take complex topics and simplify them in a way that students could understand without even opening a textbook. That’s my goal with this guide — short and concise.

I am not a financial professional, and this guide is by no means meant to be a complete discourse on Roth IRAs. However, I hope it sparks your interest in saving for your future and encourages you to do more research on your own. Now let’s get started with the basics.

Why should you have a Roth IRA?

If someone told you there was a way to earn tax free money for retirement, would you turn it down? That’s exactly why you should have a Roth IRA. Any money you put into a Roth IRA grows completely tax free, which means you won’t owe the government a single penny when you cash it out in retirement.

However, a more convincing reason to start saving while you’re still in college is because time is on your side. For example, a 25-year-old who contributes $5,000 each year until he retires and makes an average annual return of 8% on his investment will have $1.4 million saved when he retires at 65.

The earlier you start, the less money you will have to initially invest to reach the same goal. Why? The power of compounding favors the young as demonstrated by this short presentation.

In less scientific terms, think of your retirement goal as a giant mountain to conquer. You have a way better (and easier) chance of making it to the top if you start now while you’re young and healthy rather than waiting until you’re old and crotchety.

Retirement mountain

What is a Roth IRA?

Now that you know why you should have a Roth IRA, let’s dig into some of the details. A Roth IRA (Individual Retirement Account) is a tax-advantaged investment account that helps you save for retirement. The key thing to note about a Roth IRA is that it’s just an account. It’s not an investment.

Within your Roth IRA, you can hold a variety of different investments — stocks, bonds, mutual funds, CDs, real estate, etc. A Roth IRA is simply a vehicle to hold all of your investments as you head towards retirement.

Retirement vehicle

Like car brands, there are different types of IRAs, but the two you hear most about are the Traditional IRA and the Roth IRA. The main difference between these two accounts is when you get the tax advantage. With a Roth IRA, you pay taxes now. The money you put into it has already been taxed, but then it grows tax free. With a Traditional IRA, you pay taxes later. The money you put into it now is tax deductible, but the money you withdraw at retirement will be taxed.

Roth IRA vs Traditional IRA

Who is eligible for a Roth IRA?

If you have earned income (a job), then you can open a Roth IRA. This means practically every college student should be eligible. (If not, get a job!) If all you have is money from your parents and leftover student loan money, you cannot put this into a Roth IRA unless you have a job. (Get a job!) Also, you can only contribute as much money as you’ve made, so if you just made $2000 from a summer job, you can only contribute up to $2000 for the year.

There are also limits on how much you can contribute based on your income, but college students definitely don’t have to worry about these yet. As long as your income falls below $101,000 if you’re single and $159,000 if you’re married and filing a joint tax return, you can contribute the full $5,000 in 2008.

What should I do before I open a Roth IRA?

Now that you know why you should open a Roth IRA, what a Roth IRA is, and whether or not you’re eligible for one, there are a couple of things you should take care of before taking the plunge.

  • Pay off your credit card debt. You should eliminate all of your credit card debt before you even consider opening a Roth IRA. The power of compounding works against you when it comes to credit card debt. Since credit cards have high interest rates, you’ll most likely come out ahead if you get rid of that debt before investing in a Roth IRA.
  • Have an emergency fund. The last thing you want to happen is for an unexpected emergency to come up right after you put all your money into a Roth IRA. You’ll probably rack up some credit card debt that will end up offsetting the money you saved. How much you should have in your emergency fund will vary depending on your situation. If you have a car, you may need more. If you’re getting financial help from your parents, you probably need less.

Where should I open a Roth IRA?

So you’ve decided that you’re ready to open a Roth IRA. Now comes the tricky part — deciding where to open it and what to invest in. You can find tons of recommendations by doing a simple Google search, but now it’s time to add my opinion into the mix.
The Vanguard Group
For beginning investors, I recommend keeping it simple, and there’s nothing simpler than a no-cost Roth IRA at Vanguard. If you elect to receive electronic statements, Vanguard waives the custodial, low-balance, and maintenance fees on your account. With no fees and great investment options, Vanguard is where I currently keep my Roth IRA.

A minimum initial investment of $1000 is required to open a Roth IRA at Vanguard, which will allow you to invest in the company’s STAR fund. This is a mutual fund of mutual funds, which is a good choice for beginners. Additional contributions require a minimum of $100. Here’s a great personal account of what’s involved in starting a Roth IRA at Vanguard.

As you continue to contribute to your Roth IRA, your investment options will expand. Most of Vanguard’s more popular funds require a minimum investment of $3000. Once your Roth IRA reaches $3000, you can switch over to a Target Retirement Fund. These broadly diversified funds gradually become more conservative as your year of retirement approaches, which means you can just set-it-and-forget-it.

That’s all folks.

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