4. An IRA: Every American’s Treasure Trove

If you have earned any money working this year, you can open an IRA or a Roth IRA. And you should.

If you haven’t worked for pay but have a spouse who has, you can still open an IRA or a Roth IRA. And you should.

In fact, even if you are in elementary school and mow lawns, wash cars, baby-sit, or do anything else for pay, you can open an IRA or a Roth IRA. And if you do, you will be setting yourself up to become a millionaire.

That’s because IRAs, particularly Roth IRAs, are powerful money-making machines. And the earlier in life you start one of these miraculous individual retirement accounts, the wealthier you will be.

Nothing makes the point more clearly than an illustration often used in seminars to educate financial planners: Jack Surgent, a certified public accountant in Devon, Pennsylvania, who trains planners, explains how one of his clients is turning a child into a multimillionaire. It all started when the child got her first IRA when she was only about two years old. Here’s what’s happened.

Surgent’s client is a businessman who used photos of his toddler in business promotional materials. Then he paid the child $3,000 for being a model and put the entire paycheck into a Roth IRA for her.

It was perfectly legal. Although the toddler didn’t know it, she was doing work for pay. That’s the criteria that must apply when opening an IRA or a Roth IRA, a close relative of a regular IRA.

Look at the impact of this creative strategy: Surgent notes that if the parent repeats the same process of paying his child $3,000 a year for modeling for each of the next three years and puts the money each time into the Roth IRA, the child will be a millionaire when she retires in 60 years. Actually, it’s a lot better than a millionaire. It’s not far fetched to anticipate $4.2 million if she averages a 10 percent return per year.

And here’s the shocking part: The child will use only a total of $12,000 of her own pay—just $3,000 a year for four years—to amass that fortune. If she never adds another penny of new money to her Roth IRA after she is 5 years old, she is likely to accumulate her $4.2 million fortune.

So if finances get tight later in life or she gets busy sending her own kids to summer camp and college as she ages, she won’t have to worry about saving for retirement.

Keep in mind there are no bizarre get-rich-quick investment strategies or hot stock tips involved here. Surgent isn’t suggesting anything other than a simple investment in a stock mutual fund that invests in the entire stock market. I explain how to make such an investment in Chapter 13, “Index Funds: Get What You Pay For.” But if that investment simply earns 8 percent on average a year, the toddler model will go into retirement with about $1.4 million.

How can this be? How can you turn $12,000 into $1.4 million without any slick tricks whatsoever?

It happens for two reasons: First, the child is so young that she has years upon years to earn interest on that $12,000, using the magic of compounding described in Chapter 2, “Know What You’ll Need.” Second, an IRA— whether a traditional IRA or a Roth IRA—doesn’t get taxed at all while the money sits in the account, growing bigger and bigger over the years.

I explain the difference between a traditional IRA and a Roth IRA in the next chapter. For now, just think of the two IRAs as brothers—similar in many ways, but with a few unique characteristics when it comes to profoundly helpful tax savings. Both shield your tiny savings from taxes so that you accumulate hundreds of thousands of dollars—or, after many years, even millions. So when I refer to IRAs, I am referring to what either a Roth IRA or a traditional IRA will do for you. And a little later, I explain the fine points and help you select one.

Now, I want you to understand that, similar to the 401(k) I described in the preceding chapter, an IRA (whether a traditional IRA or a Roth IRA) has a “Keep Out” sign on it meant specifically for the IRS. Uncle Sam stays away from the interest (or “return”) you earn during all the years of saving and investing. The toddler’s money can turn into $50,000, and the IRS won’t touch a penny of the earnings. It can become $500,000, and the “Keep Out” sign will keep turning the IRS away. It can even turn into $5 million, and at tax time each year, the government still won’t show up and ask for anything.

In fact, if you use a traditional IRA correctly, the only time Uncle Sam shows up with an outstretched hand is when you retire and start taking some money out of the account. Then you pay taxes just like you would on a paycheck. But you pay taxes only on the amount you take out of the account per year. The money in the account can still keep growing, untouched by Uncle Sam. That’s valuable.

Consider an example. Imagine that you save throughout your entire life in a traditional IRA and have $500,000 in it when you retire at age 65. You aren’t getting a paycheck from a job anymore, so you plan to start using your IRA to give yourself a paycheck for living expenses and fun. You take $20,000 out of the IRA for the year and pay taxes on it, just like you would on a regular paycheck. Meanwhile, the $480,000 left within the IRA is still growing, nicely protected from taxes.

Roth IRAs are even better than this. Uncle Sam stays away forever, even after you’ve retired. But more about that later.

The key is this: With any IRA, you get a fabulous deal that you cannot get with a savings account or a mutual fund that isn’t protected in an IRA or a 401(k). Remember, Uncle Sam anoints both IRAs and 401(k) plans with tax protection. If you save your money anywhere else, Uncle Sam shows up every year at tax time and requires that you give him some of the money you earned. Then you’re basically throwing away the easy money.

How much? Say you are in the 25 percent tax bracket, you have $10,000 invested for retirement, and you earn 8 percent a year on the money for 35 years. If the money is protected in an IRA, you’d amass about $148,000. If you invested the same money in an account that Uncle Sam can access, you’d end up with only about $77,000.

As of this writing, Congress is worried about the lack of saving by Americans and is considering other inducements that will help you save without paying taxes. In the future, you might encounter more tax-protected types of accounts that will work as well as today’s IRAs or 401(k) plans. No matter what the government ends up calling these future accounts—whether it’s a traditional IRA, a Roth IRA, a 401(k), or a newly designed account with a name like Lifetime Super Duper IRA—these accounts will be valuable to you for one key reason: You can build up savings without paying taxes. That’s potentially worth hundreds of thousands of dollars to you. If you bypass any of these accounts and depend instead on those without tax savings, you will shortchange yourself thousands of dollars.

Let’s go back to the lucky 2-year-old who put her $12,000 in modeling money into a Roth IRA before she could even read. If her father had put that money into an account that would have been taxed every year, she would have ended up at retirement with only about $1 million instead of the $4.2 million.

The message is irrefutable: Save money in a traditional IRA, a Roth IRA, a 401(k), or a combination of them because they are protected from taxes. If you are young enough, you might even be able to turn $20 a week into $1 million. Certainly, saving this way is the easiest route to building up retirement money without living like a pauper when young or old.

More on the Magical Power of Compounding

While you have the rich toddler on your mind, I want to return briefly to the miraculous principle of compounding I explained in Chapter 2. Watching compounding turn $12,000 into $4.2 million should be a constant motivator from this day forth. Hopefully, it will entice you at any age to put whatever cash you can possibly spare to work in an IRA, to make compounding work for you. Starting now gives you a jump on the future.

Ignore compounding, and you will have to live more like a pauper late in your savings years or during retirement than if you had simply started saving—or saved more—a few years earlier.

Let’s look beyond the toddler. Imagine a 16-year-old with a job and a benevolent grandparent. If she puts $2,000 a year into a Roth IRA, does the same thing for the next six years, and never deposits another penny of new money, the 16-year-old will have $1.1 million at age 65 if it grows by 10 percent a year on average. That’s $1.1 million for what? Just $2,000 for each of seven years, or a total of only $14,000 out of pocket.

Compare that to a person who doesn’t start a first IRA until age 32. That person can contribute $2,000 every single year until retirement and won’t come near the $1.1 million. Even if she earns the same 10 percent a year as the younger saver, she will have less than $500,000. She took a total of $66,000 out of pocket to end up with about $600,000 less at retirement than the 16-year-old with a helpful grandparent.

Now let’s look at it a little differently. Let’s say you’re like most people, and your father wasn’t working with a financial adviser clever enough to put you on the road to becoming a millionaire when you were a toddler. And Granny wasn’t capable of throwing $2,000 your way when you were a teenager.

Instead, you open your first IRA when you are 25 years old. Your paycheck is much too small to allow you to put the maximum of $5,000 into an IRA. But you decide to dig deep and come up with $3,000. You open your first IRA, and every year for the rest of your working life, you put another $3,000 into the IRA. And let’s assume that you average a 9 percent return on the money each year, a more modest expectation than I used for the 16-year-old.

When you retire at age 65, you will have about $1.1 million. And what did it take to get there? Only $3,000 a year, or $250 a month. In other words, to have $1.1 million, you had to take a total of only $120,000 out of your pocket for the full 40 years. Not bad! Compounding did most of the heavy lifting for you, and because the money was in an IRA, Uncle Sam kept his hands off, too. Consequently, you didn’t have to sacrifice and live like a pauper when you were young—and you won’t have to when retired, either.

Let’s say you didn’t start at 25 because rent was killing you. Ten years pass, and you are 35. You are now suffocating from house payments and haven’t stashed away a penny for retirement. But the news stories about the demise of Social Security are starting to make you worry. So you kick into action and put $3,000 into your first IRA. You’ve got the commitment in place now, so for every year until retirement, you put $3,000 into an IRA.

But the 10 years you lost between your 25th and 35th birthdays were very valuable. Instead of having the $1.1 million that you would have had if you had started stashing away $3,000 a year at age 25, your $3,000 a year in savings will end up at less than $500,000, even if your investments make the very same return as we assumed for the 25-year-old: 9 percent a year.

You can fix this, of course, but it will cost you. If you want to amass $1 million, you have to save about $6,730 a year every year until retirement instead of $3,000. So for the next 30 years, you remove almost $202,000 from your pocket, put it into your IRA, and average a 9 percent return annually on your investments. You won’t get to the $1.1 million that the 25-year-old amassed by giving up a mere $120,000 over her working years to build a future, but you still accumulate a nice sum without causing yourself great pain.

But now let’s look at the painful way of saving for retirement. Perhaps the house payments and the wear and tear on the paycheck from everything from rising energy costs to soccer equipment for the kids have made saving seem impossible for the past 20 years. You are 45 now, with nothing saved for retirement. Soon the kids will be starting college, and you gulp at the $100,000 four-year-college price tag. But you tell yourself that saving for retirement is now or never.

So you come up with $3,000, open an IRA, and do the same thing year after year until you retire at 65. Like the 25-year-old, you are making a 9 percent annual return on your money. But the outcome is nowhere near $1.1 million. Instead, on retirement day, you will have accumulated only about $167,000.

If you decide at age 45 that you still want to shoot for $1 million, you might still be able to do it. You might not have to live like a pauper, but you will definitely have to dig deep into your pocket and make some sacrifices. To get to $1 million in 20 years, if you earn a 9 percent return on your investments, you will have to stash away about $17,900 a year. That’s a total of about $358,600 out of pocket for 20 years. Compounding is still doing the heavy lifting for you, but with only 20 years before you retire, even magic has its limits.