Raegan’s Roth Journey Begins

Because she works and has “earned income” (a must in order to contribute to a Roth IRA), Raegan is carefully researching the possibility of opening a Roth.

Today I introduce to you a promising member of my Gen Z audience. Raegan is a bright, shiny new penny with energy and intellect to burn and appears to be well on her way to a successful future.

My mission with this blog is to show Raegan and her friends that if they consistently save and invest early in life, they can accumulate mind-boggling sums of money thanks to The Amazing Power of Compounding. It requires nothing more than a simple plan, a few bucks, and a truck-load of patience, but starting NOW is the key! And in my humble opinion, core equities for the average young investor are index funds. They offer quality, low-cost, highly diversified products that yield market rates of return – all the investor provides is a steady flow of savings and the patience to stay put while others run for the hills during volatile times.

Raegan is 20 years old, a university junior pursuing a challenging double major. She also works to help fund her own education, and behold, SHE’S SAVING A FEW BUCKS A MONTH, TOO! Raegan also carefully selected her parents (jesting) who provide encouragement and occasional financial support along the way. With parental assistance and by working 25 or so hours a week, Raegan just might graduate from college without that burdensome anvil called a student loan hanging around her neck, and maybe… just maybe… an IRA in her handbag of early financial accomplishments.

Here’s some brief insight into her thinking. Because she works and has “earned income” (a must in order to contribute to a Roth IRA), she is carefully researching the possibility of opening a Roth, saving $100 per month while in college (including a couple of years in graduate school), and possibly investing some of her initial savings in a Vanguard Target Retirement 2060 Fund. Target Date Funds are designed to shift to a more conservative blend of investments as the investor grows older. This fund invests in Vanguard index funds beginning with an allocation of approximately 90% of assets in stock and 10% in bonds.

To buy into this very low-cost (currently .15% per annum), relatively high-risk fund (four on a scale of five), Raegan will initially have to accumulate the required minimum investment of $1,000. As to the risk factor, she’s young and the Target Retirement 2060 Fund will assure that she’s properly diversified with a collection of domestic and international stock and bond index funds. As to the potential reward, over its eight-year life, this fund has yielded just over 9%, but this yield might be a bit deceiving…its total history is bounded by the current 10-year bull market. For this reason, the cautious, conservative Raegan is assuming that her long-term investment yield will likely be a more moderate 6% or so. But who knows for certain.

Raegan also understands that money saved and invested within the confines of a Roth, unlike a bank savings account, has certain limits on future access². Because Raegan will have already paid taxes on her Roth IRA contributions, qualified withdrawals from the account in retirement are 100% tax-free as long as it's been open for at least five years and the account’s owner is age 59 ½ or older. Raegan also is aware of an obvious downside to a Roth…its lack of an immediate tax benefit. Why? Earned income contributions to a Roth are after-tax.

For a terrific summary on IRAs, she might suggest that her fellow travelers check out The Motley Fool's Beginner's Guide to Understanding the Roth IRA (for beginners). For a review of IRAs in general go to Vanguard's Size up the basic IRA types.

Ultimately, Raegan will make up her own mind about how much to save and how and where to invest, but more importantly, she has begun her personal “private investor” journey at a very young age. So, let’s take a look at a couple of hypotheticals she might very well experience along the way, starting with the seed money of $1,000 and a monthly Roth IRA savings plan.

Let’s assume that Raegan saves the $1,000 minimum and invests it plus a $100 per month for the four remaining years of her college experience, and that she does, in fact, earn 6%, compounded quarterly, on her Target Retirement 2060 Fund. Upon graduation, four years hence, she checks her Roth IRA and finds an accumulated balance of $6,700. Thrilled with this result, she decides to stick with the $100 per month saving commitment for an additional 40 years (Note: Raegan will no doubt expand her portfolio to include many other retirement assets during those 40 years, but let’s concentrate for the moment on her Target Retirement 2060 Fund). What will the fund be worth after the initial $1,000 investment and after 44 years, earning 6%, compounded monthly? Wow! $271,100. Surprised! Don’t be. You’re witnessing the amazing power of compounding.

Next, let’s assume that instead of sticking just $100 a month in the Target Retirement 2060 Fund, post-graduation, Raegan decides to increase her savings rate by $100 per month at the turn of each decade. She’ll start off with the same $6,700, post-graduation, but over the next 10 years she will invest $200 per month, then $300 per month, then $400 per month, and finally $500 per month (for the last 12 years), earning the same 6%, compounded monthly. You’re going to be surprised. Upon retirement, her Roth balance could total a whopping $725,500. And what if she had been too conservative in her yield estimate, and it turned out to average 7% instead of 6%? In the 7% case, she might end up with almost a cool million bucks ($959,000 to be more precise) in her Roth IRA that she will be able to take out TAX FREE.

Of course, we’re speculating on long-term yields in the above cases, but nice going, Raegan, if you are able to meet these wonderful goals!