BOSTON ( TheStreet) -- I finished college in the early 1990s and, much like today, it was not the most auspicious time to graduate. Jobs were scarce, salaries were low and bonuses were few and far between.
Luckily, I got a job and, despite a tight budget, one of my first priorities was to save 10% of my income every year and put it toward retirement. Planning for retirement at such an early age may be difficult, especially during a slow economy, but there are so many benefits it's worth scrounging a bit while you're young to reap the rewards later.
Roth IRAs were not introduced until 1997, but they would have been my first choice of retirement savings in my 20s and 30s. A Roth IRA is a retirement account that grows tax free and to which an individual (as a single filer on a tax return) whose modified adjusted gross income is up to $107,000 can contribute up to $5,000 a year ($6,000 if you are 50 or older).
Unlike contributions to a traditional IRA, your contributions to a Roth IRA are nondeductible, meaning they are made with after-tax dollars. As a result, when it comes time to take money out of a Roth IRA, all of the distributions, including the earnings, are potentially tax free.
Roth IRAs follow the "first in, first out" or FIFO rule to determine whether the portion taken out of the account will be taxed. Under this rule, distributions from Roth IRAs are considered to come out contributions first; followed by conversion contributions; and lastly, earnings on your contributions.
What's important to note is that your contributions to a Roth IRA are
subject to either income tax or the early withdrawal penalty tax when you take a distribution. This makes it easier to make the decision to start contributing to a Roth at an early age. With a Roth IRA, you continue to have access to the amount you contribute without fear of being penalized from a tax standpoint. This is especially important in your 20s and 30s, when you are unsure whether you may need to tap into that money down the road.
Say, for example, that you contribute $5,000 to a Roth IRA when you are 25. Three years later, the account grows to $6,000, with contributions making up the first $5,000 and earnings from that investment making up the rest. Using the FIFO rule, in this example, you can take up to $5,000 out of the account without any income or early withdrawal tax.
For the earnings to be tax free as well, the distribution would need to be "qualified." This means you would have to wait at least five calendar years before withdrawing money. In addition, the distribution would have to be one of the following: taken out after age 59.5; taken out after one is disabled; used toward the purchase of one's first home; or for a beneficiary or the estate of the account owner.
While there are many rules surrounding the Roth IRA, the potential for savings is profound. Contribute $5,000 to a Roth IRA at the beginning of every year from age 25 to 45 and, at a 5% annual rate of return, the account would grow to approximately $173,596. And, if the distributions are qualified as described above, the money could be withdrawn without tax or penalties. That alone is enough reason to start saving in a Roth as early as possible.