Friday, August 30, 2013

Why graduate and PhD students should open a Roth IRA

So you've made a budget and opened a savings account, and you've begun to read up on investments. You know that while your graduate student and PhD stipend isn't luxurious by any means, you can eek out some savings from it and can translate those savings into a solid cash flow through sound investments. What type of investment account do you now open, however? What is the best fit for you as a student?

The first account you should arguably open as a student is a Roth IRA (Investment Retirement Account). A Roth IRA has several unique advantages as an investment account that makes it appealing to students, including tax-free growth, natural exposure to the impact of compounding upon your investments, and a commitment to long-term vision and growth.

Tax free growth: The Roth IRA is a very unique investment account since it allows your investments to grow tax free. The catch is that a single individual can only put $5,500 of your already taxed income into the account during each calendar year. While you can always withdraw the principal (your original investment) from the account, you cannot access any of its earnings until you reach the age of 59 and 1/2, unless you are willing to pay a fee.

Allowing your investments to grow tax-free will result in a much higher return of investment. With a regular brokerage account, you pay taxes on the money you earn through capital gains and dividends. Also, when you seek to liquidate your investments, you pay a capital gains tax. A capital gain is essentially how much money you have earned through the growth of your investment. For instance, if you buy one stock in 2013 for $50 a share, hold that stock for ten years until it matures to $100 a share, and sell it, you have a capital gain of $50 that the government will tax. In contrast, a Roth IRA will allow your investment to grow tax free every year and to cash out your stock and bond holdings without paying any tax at all, again granted that you wait until you turn 59 and 1/2.

Compounding: Investing in a Roth IRA at an early age is a great idea because it allows you to take advantage of the impact of compounding. Because you are unlikely to withdraw money from your Roth IRA until you have reached retirement, any earnings made from your investments will be added directly back into your principal investment amount. Adding these earnings back into your principal investment allows your earnings to compound upon one another over the years, which results in a much higher total investment.

For instance, let's say you invest $10,000 in a total market index fund. In the course of one fiscal year, that fund will hypothetically grow at a rate of 7%. If you were to re-invest your earnings from its growth and its dividends, you would increase your principal investment to roughly $10,700. In the year to come, re-investing your earnings will allow you to hypothetically make even more so long as the market grows. After five years of similar growth, your investment would grow to $14,025. Over time, your earnings start to compound on one another, allowing you to earn significantly more money on your investment than if you just withdrew your earnings every year and spend them. For example, if your initial $10,000 investment grew at a rate of 7% per year for 35 years, you would wind up with $106,765.81. This ten fold increase results from the market compounding your investment returns over time.

As a graduate or doctoral student, your stipend will likely be small relative to a full-time salary, and the amount of money you can set aside as savings or to invest will also be smaller than if you worked a full-time job. This is a sacrifice almost every student is willing to make because they love their field. You don't have to sacrifice financial soundness, however. Because of the tax-free advantages and the impact of compounding, a Roth IRA will help you to maximize the potential of your savings.

Long-term vision: students are often first time investors and for this reason benefit from locking into a long-term investment strategy. The difficulty of a short-term vision is that the market is often volatile over a short-term window. Actively responding to all of the market's ebbs and flows constitutes a time-consuming and demanding task. In the end, responding to all of the market's micro-fluctuations often befuddles first time investors and leads to a net investment loss. Furthermore, as a time strapped student, you likely do not have the time to follow all of the economic news.

Over multiple years, however, all of the market's smaller ups and downs generally smooth out into a gradual uphill climb. Through making sound investments in well-known and respected companies or just investing in a total market index fund and holding those investments for multiple years, you as a student can rest more soundly knowing that your invested money will likely grow. A Roth IRA naturally locks you into this long term vision. If you begin investing in your 20s, you will not be accessing your invested money until your 60s, which leads you to think long-term. Of course, you can always buy and sell investments within your Roth IRA at any time and reinvest your money in new stocks, mutual funds, or index funds within your Roth account. This means you do not lock yourself into your original investments for all-time; rather, your Roth IRA should naturally lead you to holding those investments for the long haul.

For these reasons listed above, a Roth IRA is arguably the best way to build up a small nest egg for your retirement. Starting an account as a student and even contributing a modest amount of money each year can help ensure that even your student years will contribute to your long term financial health.

While you might be intrigued about the Roth IRA now, there is one important step to clear to ensure that you can contribute to a Roth account with your stipend money. Here's the deal:
  • Make sure your graduate stipend is considered "earned income":
    • Based on IRS regulations, you can only contribute "earned income" to your Roth IRA. Unfortunately, in some states and for some universities, your stipend is not considered earned income. This is rather bogus, as graduate students do work for universities, whether through teaching or assisting in research. Unfortunately, stipends are often lumped in as "fellowships" or "scholarships" which fall into murky tax categories that involve you not working in exchange for an income. As such, there is the chance your stipend may not be considered earned income.
    • The easiest way to learn whether your stipend is considered earned income is to contact your department's graduate secretary or the finances department of your graduate school. Ask them about the tax status of your stipend and specifically about graduate students contributing to a Roth IRA.
    • Another way to check is through the type of tax form you receive from your university. If you receive a W-2 form, you are in luck and your stipend is considered earned income! If you receive a 1099-MISC form or some other tax form, however, your stipend is sadly considered non-earned income, and you cannot invest in a Roth IRA. 
If you cannot contribute to a Roth IRA, don't sweat it. There are a multiple other solid investment choices, such as a savings account or a regular brokerage account with one of the firms I list below. While you won't reap the tax-free benefits of a Roth IRA, you can still use your stipend to invest money and see some financial growth.

If you are in the lucky position to contribute to a Roth and want to take the plunge, here are a few things you should consider in choosing where to open your Roth IRA:
  • Is there a minimum investment amount? 
    • Most accounts will require a certain minimum investment amount. A decent range is about $1,000 - $2,500. You will need this amount to come from a taxed paycheck and to be sitting in a bank account so that you can transfer it over into the Roth IRA.
  • Are there minimum contributions per year?
    • A good account will not require you to contribute every year. This is a nice feature for students to have in case they need to readjust their earnings towards cost of living expenses.
  • What sort of fees are tacked onto the account?
    • Definitely look for a no-fee account.
In the past, I've touted the benefits of both Fidelity and Vanguard. They are both widely respected and known for their quality customer service to their investors. I originally held an account with Vanguard but switched over to Fidelity in 2009. Here are some quick remarks on the benefits of a Roth IRA with these two firms:
  • Fidelity
    • No fee Roth IRA
    • No minimum required distributions
    • Requires an initial deposit of $2,500
    • Access to hundreds of mutual funds, including commission free trading on select Fidelity funds and ETFs
    • Established investment centers where you can get professional advice
  • Vanguard
    • Annual fee of $20 waived if you sign up for an online account with e-delivery
    • Initial deposit can be as low as $1,000 with certain provisions
    • Very low expense ratios on most of their mutual and index funds
Whether you are ready to open a Roth IRA now or are just seeking to learn more, remember a Roth IRA can be one of the best ways to go for a student starting out as an investor!

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