This Special Account Lets You Save for Retirement, College, and a House All At Once

published Sep 14, 2020
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It’s tough to save money, period, much less to sock away enough funds for all the competing expenses we might face in our lifetimes. Even most low down payment programs for first-time homebuyers require you to pony up at least a few thousand dollars, if not a much larger chunk. Maybe you’re hoping college will be free by the time your two-year-old graduates high school, but what if it isn’t? And if you ever hope to escape the grinding gears of the capitalist machine, you’re going to need a heck of a lot more than $24,000—the median amount of retirement savings among Millennials, according to the Transamerica Center for Retirement Studies

Saving for any one of those goals is daunting enough, much less some combination of the three. So where do you even begin? Well, there’s one fabulously flexible, tax-advantaged savings account that allows you to save toward all three at once: the Roth IRA. 

Unlike a workplace 401(k) or a traditional IRA, a Roth IRA is funded with after-tax dollars—meaning your take-home pay, the way you might transfer $100 from your checking account into savings. That doesn’t sound particularly special, but it makes a huge difference. Since you’ve already paid your share of taxes on it, the money in a Roth IRA is allowed to grow tax-free. So unlike those other retirement accounts, when you withdraw your money from a Roth IRA after age 59 ½, you’ll pay no taxes on it (as long as you’ve had the account for more than five years). 

(To use an extreme example, let’s say a 40-year-old put $1,000 into a Roth IRA 20 years ago, and was prescient enough to invest it all in Apple, never touching it again. By now, at age 60, it would be worth over $100,000, and she could withdraw every penny completely tax-free.) 

But the Roth IRA has other key perks, too, that can make it a useful all-purpose savings vehicle. It allows you to pull money out before retirement age under a few special circumstances. 

A Roth IRA allows you to withdraw, without penalty:  

  • up to $10,000 to put toward your first home;
  • any amount to pay for qualified educational expenses, such as tuition, fees, or books;
  • money to cover costs related to a child’s birth or adoption; 
  • any amount in the event of a disability, or to pay for medical expenses while you’re unemployed.

What’s more, you can withdraw your contributions (meaning the money you’ve already put in, but not any investment gains or interest earned) at any time, for any reason, without paying a penalty or taxes. That means you can save aggressively, with the peace of mind that you could tap your Roth IRA as an emergency fund of last resort if you must. (In the above scenarios, you can even withdraw your earnings before retirement age without paying the typical 10% penalty. However, you’d owe regular taxes on any investment income pulled out before age 59 ½.)  

Because of all those perks, there are limits to who can contribute to a Roth IRA, and how much. Like traditional IRAs, contributions are capped at $6,000 per year (or $7,000 if you’re over 50). But Roth IRAs have income limits as well: In 2020, single taxpayers earning up to $124,000 and married couples earning up to $196,000 are eligible to contribute all $6,000 per year to a Roth IRA. People earning more than that can contribute reduced amounts, until eligibility phases out completely at $139,000 and $206,000, respectively.

The beauty of the Roth IRA is the flexibility it offers as you try to save toward competing goals on varied timelines. Put in as much money as you can afford to set aside, knowing you might tap some of it for a down payment. But, if you continue renting, your house fund can instantly be reinvested toward one of your other savings goals. If your kid gets a scholarship or doesn’t go to college? Let that extra money keep growing for your retirement. And if you’re facing financial catastrophe, you can pull out some stashed cash without owing taxes or paying a penalty. 

I’m no financial planner, but here’s an over-simplified example of how you could use a Roth IRA to save for all three goals. Let’s say you hope to buy a home within three years, you want to set aside some money for your child’s education in 15 years, and you’re hoping to retire in 35 years. 

A good rule of thumb is not to keep money in stocks that you’ll need within 5 to 10 years, because if there’s a crash, you may not be able to wait for the market to fully recover. So you’ll want any money earmarked for your down payment to be in a safer, short-term investment such as CDs, government bonds, or a money market account. 

Meanwhile, if retirement is still three or four decades away, you’d probably want that money in a pretty aggressive stock portfolio to maximize growth. If there’s a major crash, you have plenty of time to wait it out. 

And when it comes to your child’s college money, you might want it to be invested aggressively for the first few years, but get incrementally more conservative as freshman year approaches. 

To achieve all three, you could simply divvy up your contributions into different target date funds. These are low-cost mutual funds that automatically adjust their investment mix as time goes on, gradually shifting from riskier stocks into safer investments as the target date nears. 

Let’s say you’re able to sock away the full $500 a month. You could set your account so 50% of contributions get dumped into a 2060 target date fund for retirement, 10% go into a 2035 target date fund for college, and 40% go into a CD or a high-interest savings account for the house. (Most financial experts say to prioritize retirement savings over college, since student loans are easy to come by but nobody’s going to lend you money to grow old.) 

After three years, you’d have about $7,500 in your down payment fund—though you could pull out another $2,500 without penalty if you needed to. From that point on, you could increase your college and retirement contributions—using, say, a 60/40 split. By year 15, you’d have about $43,000 saved up to help with your kid’s tuition bills (and you could access another $60,000+ in prior contributions if you really needed to, though it’s not recommended). After that, going all-in on retirement with the remainder of your $500-a-month contributions would leave you with about $920,000 by 2060—all yours, all tax-free, and all from the same uniquely powerful investment account. 

(Note: We’ve assumed a 2% interest rate on CDs or savings, 5% average return on mid-term college investments, and a 7% average return on long-term retirement investments.)