How do you turn a penny into a million dollars? Try Roth IRA accounts

Column by Adam French

Suppose I gave you these scenarios to choose from: either I give you $1,000 today, no questions asked, or I give you a penny today, double it tomorrow to two pennies, and continue to double my gift to you every day for a month.  Most people – without thinking – easily choose the $1,000 gift on the first day of the month due simply to the fact that it sounds like a much better deal. The initial payment of $1,000 seems vast compared to an initial payment of a penny, regardless of the future conditions of that choice.

In economics, we often hear the term “opportunity cost.”  Opportunity cost is defined as the value of the next best alternative that is forgone when a decision is made.  For example, if Saturday night’s choices are going to a movie or going bowling, the opportunity cost of going to the movie is whatever entertainment value is placed on going bowling, and vice versa.  For the opening scenario to this article, the opportunity cost of choosing the $1,000 – as most people would blindly pick – is $5,368,709.12, which is the value of a penny a day doubled for a 30-day month.  Such is the beauty of compounded interest and in this case a 100 percent interest rate.

Why is this relevant?  For one simple reason – there are opportunity costs to each and every dollar we spend, even as typically poor college students.  As poor college students, we make some decisions every single day that cost us in the future, whether we know it or not.

As an example, take the money spent on alcohol and cigarettes for a typical college student over the course of a year.  Assuming – and this is only an assumption for the sake of proving a point – that as a college student, you spend $20 a week on booze (a case of Bud Light in cans typically sells for around $18) and an additional $5 for a pack of cigarettes.

Assuredly, this is a very high estimate for some of you, and a very low estimate for others.  Also, rest assured that this article is not meant to sound preachy or condemn people for partying while in college – I certainly did, to little regret.  However, this $25 spent in a week’s time on these vices amounts to $1,300 in the course of a year.

Now let’s revisit the ideas of opportunity cost and compounding interest.  If a college student opened up a Roth Individual Retirement Account (IRA), which is a collection of investments in different types of securities such as stocks or mutual funds that together make up an individual retirement account, he or she could place this $1,300 in the account over the course of a year’s time.

Assuming that this account is started at age 18 in college with an expected retirement age of 60, and assuming that the $1,300 contribution was made each year for 42 total contributions, with an 8 percent annual rate of return, the contributions would grow to $395,517, assuming a 3 percent inflation rate (or $175,801 with inflation taken out of the picture).

It may seem trivial to consider retirement as a college student, so the numbers above may not seem to be that big of a deal – you can always save for retirement later, right?  The fact of the matter, however, is that Roth IRA accounts are most beneficial to people who begin investing earlier as opposed to later.

For example, with the same assumptions as before, if you wait until you are somewhat established to begin contributing to the same account and start making your $1,300 payment at age 30 as opposed to age 18, the value of the Roth IRA at age 60 drops to $147,268 before inflation — a decrease of over 60 percent. Basically, the money we spend to party in college is costing us not only the money we could have upon retirement, but also the prime years in which to be investing for the future – definitely something to think about next time you swing by Liquor Barn.

Of course, our friends at the IRS have put some caveats on using Roth IRAs. The maximum allowed in a given year to contribute is $5,000 or as much money as you have earned in income over the course of the year.

For example, if your annual income is $2,500, then that is the maximum contribution you can make that tax year.  So for those of you without a job, there is an opportunity cost of being unemployed in college, as well.  Finally, contributions to Roth IRAs must cease if their holder’s modified adjusted gross income exceeds $120,000, but if you are making that kind of money in college, your retirement may be more secure than an IRA could provide.

Once again, this is a pure human interest article, not a call to quit drinking or partying in college.  I did my share of partying but have also contributed to a Roth IRA account since I was 14 years old, so a balance can be made if you plan wisely.  If you decide that a Roth IRA is for you – and you want your money to start working for you, not the other way around – then go to a reputable and secure financial, insurance or investment institution such as Chase, State Farm, or Wells Fargo and tell them you are ready to seize the opportunity cost of being a college student.  As with the penny doubled for a month, you just may be surprised by the return on this investment.

Adam French is an MBA graduate student. E-mail opinions@kykernel.com.

Excellent point… The earlier you start socking away funds for retirement, the better off you’ll be in the long-run, and the easier it will be to fully fund your retirement. Unfortunately, most 18 year olds don’t give a second thought to retirement. But those who do will reap big rewards.

It’s also a good point to mention the power of reinvested dividends. It’s certainly possible to buy a share of PepsiCo today with a 3% dividend yield, and 40 years later, receive a dividend almost equal to the original price paid for the share of stock. Reinvest those dividends in additional shares, and you’ll realize the incredible power of compounding interest…!