Should I invest in a Traditional IRA or a Roth IRA?
I recently started my first job after graduating from college. I have the option to invest in a Traditional IRA or a Roth IRA. I'm 25 years old. Which do you suggest?
Congrats on your new job! Always great to hear!
You should find out if you are eligible to enroll in your company's retirement plan, assuming they offer one. Some employers allow new employees to enroll right away, while others have a grace period of up to six months or a year before they can officially enroll. The most common employer retirement plan these days are 401(k) plans that allow you to contribute up to $18,500 pre-tax. In other words, your taxable income would be reduced by the amount of your pre-tax contribution. Some employers even match a certain percentage of your income or contributions, making enrolling and contributing to the plan even more valuable.
If you have access to a 401(k), then I would strongly encourage you to establish a Roth IRA. A Roth IRA allows your money to grow tax-free, as opposed to tax-deferred like a traditional IRA and 401(k) plan. However, some employers are now offering Roth 401(k)s. Contributions to both a Roth IRA and Roth 401(k) are done with after-tax dollars, which means you receive no tax deduction. The offset is, the money grows tax-free. And if you are just getting started, a Roth IRA can prove to be a very powerful retirement account, allowing your capital to compound over many decades without having to pay any income tax on withdrawals down the road. Even if you cannot enroll in your employer plan, you might still want to consider contributing to a Roth IRA. Depending on how much you earn, you may be able to make a tax deduction for a traditional IRA contribution, but it may be more beneficial contributing to a Roth IRA instead.
Too, unlike a traditional IRA and/or 401(k) plan, Roth IRAs do not have any mandatory withdrawal requirements. The IRS rules say people age 70 1/2 have to begin taking mandatory distributions from their IRA accounts. This is not the case with Roth IRAs.
Best of luck on your new job!
This is a great question and one we hear quite often. Congratulations on starting your career after college and thinking about your future. You are well ahead many of those at a similiar life stage.
I would recommend that you consider using the Roth IRA at this point in time. You are young, have a long time horizon and are most likely at a relatively low tax bracket. You did not include what your expected earning are going to be so just making an educated guess. Although you will not receive a tax deduction today, like you would with the IRA, you will benefit from tax free accumulation and distribution if you follow the rules correctly. This could benefit you far greater than the small deduction you would receive today.
There may come a point in time, hopefully, in the future that your income will be too high to qualify for a Roth IRA contribution. This is yet another reason to contribute to a Roth now.
It may be worht a call to your tax advisor to simply confirm this based upon your actual tax situation.
Best of luck in making your decision and your future!
Technically, the answer should be one of taxes. If you believe that your tax rate now is lower than your tax rate will be when you eventually take qualified distributions, sometime after age 59 ½, then contributing to a Roth IRA will make the most economic sense. That is, because Roth contributions are made on an after-tax basis, and grow tax free, paying the lower tax rate on dollars contributed today will mean that less will be paid in taxes compared to pre-tax Traditional IRA contributions which grow tax-deferred, and are fully taxed as ordinary income upon distribution.
However, in my opinion, trying to predict tax rates 30 years in the future, and using that as the primary factor in making this decision, is a bit of a stretch. There are other attributes that I believe should be seriously considered when weighing this option.
If you were to make Traditional IRA contributions now, you would want those dollars to stay invested until you could make qualified distributions at 59 ½, otherwise an early withdrawal penalty tax of 10% will be applied. Although this is also true of any earnings within a Roth IRA (with the additional stipulation of a Roth IRA needing to be open for at least five years before earnings can be withdrawn, even after age 59 ½), your contributions into your Roth IRA have already been taxed and can, therefore, be distributed at any time without tax or penalty.
Obviously, leaving your contributions inside of your Roth IRA for as long as possible is ideal. I do understand, though, that, for young people transitioning into proper adulthood, sometimes access to additional capital is necessary to get started in life. Having the option to access the funds contributed to your Roth IRA could potentially be a help at some point in the future.
An additional consideration that some fail to make is that, even when it makes more economic sense to make pre-tax contributions now, the piper will eventually need to be paid. In fact, the IRS requires that distributions begin from pre-tax IRAs at age 70 ½. These are called Required Minimum Distributions. The irony is that, while people willingly scramble to make pre-tax contributions now, to lower their present taxes, some of those people eventually beat themselves up when they end up being forced to take, and pay taxes on, distributions they don’t actually need or want to take at some point in the future.
Imagine yourself 50 years from now. Do you think you will care how much you paid in taxes when you were 25 on the contributions that you made to your Roth IRA? Or do you think that you will find the option to take distributions at will - without having to pay taxes on those willfully taken distributions - more valuable?
If you want a little more to consider, here is a podcast that covers the topic pretty concisely.
All of this being said, you should still first look to your employer’s retirement plan, if applicable, and, if your employer provides contribution matching, consider making contributions up to the match provision prior to looking elsewhere.
Additionally, there are many benefits for young people that seem to make the Roth IRA a wise choice. Still, everyone’s circumstances are different. Before you decide to contribute to a Traditional or Roth IRA, it is prudent to consider all of the pros and cons of each arrangement within the context of your personal financial situation and objectives.
As you probably know, the difference between a Traditional IRA and Roth IRA is that the former is funded with pretax money and the Roth is funded with aftertax money. Since your current tax rate is probably low, it may be a good idea to open a Roth IRA. With the Roth, whatever is withdrawn in the future will not be subject to further taxation.
One of the basic considerations when choosing between the Traditional and the Roth is tax rates, both current and projected future. If the tax rate now is higher than it's likely to be in the future, it may be better to go with a Traditional IRA. And vice-versa. Another consideration is where you are in on your career path. If you're just starting, your tax rate may be lower than it would be in the future even if your earnings and tax bracket increase.
Since you are more than likely at a lower tax bracket now than you will be at retirement, opening a Roth can make a huge difference down the road. Pay a lower tax rate now and take tax free distributions later. You don't want to defer lower taxes now to pay higher taxes later, which is what could happen in a traditional IRA.
Hope this helps