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The Best IRA Strategy for Young Adults

It's never too early to start building a saving and investing mentality. Warren Buffet, for instance, bought his first stock when he was 11 years old. With the support of my father, I started investing my own funds and managing my custodial account independently at the age of 12.

But Buffett and I are exceptions. For most kids, once they begin considering options for further education (potentially leading to thousands of dollars of student loan debt) or commence a vigorous job search, there are surprisingly few resources geared toward supporting teens and young adults in their investing -- and retirement -- pursuits.

Investing strategies for retirement should not be put off until you are 25 or 30 years old or have full-time employment. IRAs are painless to open and require no minimum contributions. Even contributing $300 each year to an IRA now is far better than sitting on the sidelines until every factor is aligned perfectly. This article marks the beginning of a new series on Fool.com -- including a real-money personal IRA portfolio and ongoing insights into IRA investing -- for young investors focused on long-term results.

Why a Roth IRA makes sense 
Among the plethora of choices with investing accounts, I personally prefer a Roth IRA for younger investors. Roths are pretty straightforward: You are taxed on the money you contribute to a Roth in the present day, but, so long as you follow the guidelines, down the road you are not taxed on funds you withdraw once you hit retirement age. For younger individuals, a Roth IRA is particularly beneficial if you invest in businesses that go on to crush the market's returns over the long run. Beating the market over a long period of time and having the option to withdraw those funds tax-free further down the road sounds like a good deal to me. 

With this in mind, I am starting the Pencils IRA Project. Why this name, you ask? "Pencils" is the username my father chose when he first joined The Motley Fool in 2002, and I have stuck with that username more than a decade later. Given that my interest in investing stems from my father's inspiration, it is only fitting that I stick with his name for this project. To see how he helped me learn the importance of saving and investing at an early age, read my detailed account on The Motley Fool's discussion board.

The Pencils IRA Project is fairly simple. Each month, I will make a new investment within my Roth IRA. Ideally I will be able to contribute the maximum amount to the Roth ($5,500 this year), but the amount isn't relevant for this project. I will contribute a regular amount of money to the Roth, whether it is $100 or $450 a month, and each month I'll invest in a business that offers significant long-term potential to beat the market. 

Criteria for Pencils IRA holdings 
Here are the five necessities for the "megagrowers" to be added to this IRA portfolio:

  1. Purpose-driven business. The company must be driven by a deeper purpose, e.g. Chipotle and Food With Integrity. If "financial profit" is the only reason a company exists, then it's time to move on.
  2. Innovative products and services. This goes hand-in-hand with a purpose-driven business. Businesses like Netflix, Chipotle, and Facebook are continually reshaping their respective fields. We want businesses with innovation in their DNA. Further, these should be products and services that are understandable and relevant to us in our daily lives; we're not looking for a hidden Chinese microcap. 
  3. Visionary, experienced, involved leadership. We want leaders who think beyond the next quarter and the short-term performance of the company's stock, focusing instead on the long-term potential of a business. We want leaders capable of admitting when an error was made and redirecting course before further damage is done (e.g., Netflix's Reed Hastings and Qwikster). We want business leaders who are personally invested in a business financially, ensuring that their interests are aligned with those of fellow long-term stakeholders. We want leaders who either founded the business or have worked within the business for an extended period of time while demonstrating their commitment to maintaining an innovative and adaptive company environment.
  4. Consistently increasing cash-flow production. The company must have a demonstrated record of consistent and increasing cash-flow generation, preferably with positive free cash flow as well. This ensures that a company's prospects are backed by consistent and sustainable improvement in its financial position. 
  5. Strong company culture. Each business must have a minimum rating from employees of 3.5/5 on workplace review website Glassdoor.com. The CEO "approval rating" on Glassdoor must meet or exceed 70%. I'm interested in investing in visionary leaders who are also effective in inspiring others in the business to perform at their highest potential. 

These five points, while seemingly simple, actually weed out quite a few subpar businesses.

Foolish next steps 
This experiment will help us build a disciplined, long-term-focused IRA portfolio that can easily be tracked and modeled by other young investors. This is a small step to fill what seems to me a glaring void in investing education and services.

Each month I aim to invest in a business that demonstrates the five attributes mentioned above. After each investment I will provide a write-up detailing how the company meets these criteria. This provides for a simple and trackable long-term IRA portfolio of promising businesses. 

The IRS will weep over our non-taxable gains in the coming decades. Here's to Foolish investing for people of all ages!

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Read/Post Comments (4) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 01, 2014, at 12:15 PM, Chloe234 wrote:

    David,

    Good advice. I will share this with my kids, two of whom are still in college.

    What brokerage do you use? I ask because small investments get eaten up by per-trade fees.

    Dion

  • Report this Comment On April 05, 2014, at 10:38 AM, TMFPencils wrote:

    Hi Dion,

    I personally use Firstrade, which charges $6.95 commission for each trade. I have been happy with their offerings and service.

    You might want to check out the Fool's broker comparison, as well, to see which broker would be a good fit for you and your kids: http://www.fool.com/how-to-invest/broker/index.aspx

    If you have any other questions let me know. Fool on!

    David K

  • Report this Comment On April 07, 2014, at 12:57 PM, variano wrote:

    David,

    I am 21 Y/O and highly interested in starting a Roth IRA. My understanding of the stock market is extremely limited. Maybe you could please answer a few questions briefly.

    1. Do I have to decide what stocks my money goes into when opening a Roth IRA.(*about me I am looking to open up a IRA with TD, Iam looking to put away maximum a year. I don't have time to properly teach myself which stock to put money in.

    2. What kind of returns can I expect by the time I am 65 if I put maximum away each year.

    Any insight is highly appreciated.

    Best Regards,

    Vincent Ariano

  • Report this Comment On April 10, 2014, at 7:29 PM, TMFPencils wrote:

    Hi Vincent,

    If you don't want to spend time researching individual stocks, you could simply invest all or a portion of your Roth IRA funds into an index fund or ETF. If you were to do this, I would recommend investing a fixed amount each month into an index fund or ETF.

    There's no guarantee of future results. Over the past 40 years, the S&P 500 has grown at an average annual rate of approximately 7.78%. Since you are 21, you have approximately 38 years until you hit retirement around age 59. If you invest $5,000 each year for the next 38 years and earn an average annual rate of 7.5% (slightly below the market's average over the past 40 years), you would have $1,125,427 at age 59.

    Hope this helps. Kudos to you for asking these questions when you are 21 years old -- you are on the right track and have a great head start. Fool on!

    David K

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David Kretzmann
TMFPencils

David started investing in stocks when he was 12 years old. He is a graduate of Berea College and a member of the Motley Fool's Analyst Development Program, currently serving as an analyst in Rule Breakers. Follow David on Twitter @David_Kretzmann.

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