By Hank Coleman
Posted in Savings Account
The choices that a new investor faces are daunting. There are literally over 2,300 stocks that are traded on the U.S. stock exchanges, and there are over 8,000 actively traded mutual funds an investor can choose. That does not even count the number of index funds and exchange-traded funds (ETFs) that are available as well. It is easy to see how someone can become overwhelmed, so where should a young soldier or member of the military invest first?
The Roth Individual Retirement Account (IRA) is a type of IRA that is usually invested through a mutual fund. When you buy shares of a mutual fund, you have the option to designate that mutual fund as a Roth IRA if you are investing for retirement.
In 2010 and 2011, a person can invest up to $5,000 in a Roth IRA or an extra $1,000 as a catchup investment if you are over 50 years old. You can also fund a Roth IRA with $10,000 per year if funded in a joint account. To open a Roth IRA, an investor has to have earned an income and file taxes.
The only exception to this rule is members of the military who have no earned income because of combat deployment can still invest in a Roth IRA. Roth IRAs are a great option as a first investment because they are funded with after tax money and can grow tax free. When your investment is withdrawn during retirement, any interest, capital gains or dividends that your Roth IRA earns can be withdrawn tax free.
If you invest $5,000 per year earning an 8 percent annual rate of return–starting from the time you enter the military at age 18 until you fully retire at age 67–your retirement nest egg will have approximately $2.6 million for you to withdraw tax free and use as you see fit. If you had that money in a taxable account, you could lose $650,000 or more (assuming a 28 percent tax bracket).
Members of the military and federal government civilians have a 401(k) type of retirement plan addition to their pensions called the Thrift Savings Plan or TSP. Investors makes pre-tax contributions to their TSP account. Then, during retirement, income tax is paid on principal, interest, dividends and capital gains at the time of withdrawal. Like a civilian 401(k) retirement plan, members of the military can contribute up to $16,500 per year in their TSP account.
One reason that the Thrift Savings Plan is a great choice for first time investors is because it is easy. It is easy to enroll, change your contribution levels and withdraw money when the time comes. Members of the military and federal workers have their contributions taken directly out of their paychecks through payroll deduction. This makes investing easy and automatic.
While many financial planners debate the order in which young investors should put their money to work, the TSP offers an easy investment choice and lifecycle funds that manage diversification and risk for the military member.
Many financial planners recommend investing in a Roth IRA first if you are not eligible for company matching contributions to your 401(k) retirement plan. Currently, only federal government civilian workers are eligible for a matching contribution to TSP and should take advantage of that first. Many members of the military are in a low tax bracket because only a portion of their total contribution is taxable.
Housing and food allowances are not taxable. So, contributing after-tax dollars to a Roth IRA when the Soldier is in a low tax bracket may be extremely beneficial if he or she withdraws the money in retirement at a higher tax bracket. Because of tax consequences, many financial planners recommend maxing out a Roth IRA with their first available $5,000 for new investors before allocating their money elsewhere.
Hank Coleman is a Captain in the U.S. Army, freelance writer, and the founder of personal finance sites such as Military Money Might. His writing has been featured on The Motley Fool, Military.com, and many others. You can follow him on Twitter at @HankColeman.