I'm a millennial and so are many of my clients. I encourage all of my younger clients to begin saving for retirement by contributing to a Roth IRA or Roth 401(k) over a Traditional IRA or 401(k). The truth is one isn’t necessarily better than the other, each have their advantages and should be evaluated for your specific situation.
In general, there are three key reasons I feel Roth contributions have an edge over Traditional contributions for young people.
- Having tax free distributions in retirement is great, especially if you feel taxes are likely to go up in the future. Since younger investors have a longer time horizon, the impact of compounding growth in these accounts benefits even more from tax free distributions.
- Most young people are not yet at their highest earnings potential and tend to be in lower tax brackets at this stage in life. The benefit of deferring income taxes by making Traditional contributions to an IRA or 401(k) may not have as much of a tax savings impact as it will in the future when you are earning more income.
- There are income limits which disqualify you from making Roth IRA contributions in years which your income (includes spouse if filing jointly) exceeds a certain threshold. Ideally, one day your income will surpass that threshold, you’ll be able to keep your Roth IRA invested but can’t add to it. At this point you’ll be limited to only making non-deductible or traditional contributions which are deductible. If you have access to a Roth 401(k) you may still qualify to make contributions depending on your situation.
Ultimately, you should seek a balance of making both Roth and Traditional contributions to retirement accounts over your lifetime. It’s ideal if you can balance taking tax free and tax deferred distributions in retirement.
In my opinion the Roth IRA is the best kind for a 20-something if that individual qualifies for a Roth. The reason is simple: tax rates will probably be higher when a 20-year-old retires. Being able to access retirement savings without having to pay taxes will be a big advantage 40 years from now. One added point, there is no requirement to take an RMD (Required Minimum Distribution) from a Roth IRA at age 70 ½ like there is from a Traditional IRA, making the Roth a better estate planning tool.
There probably is no 100% correct answer here, but let's break it down.
Suppose that you are 23, you've been working for a couple of years and are now earning $50,000 per year. For 2016, you can contribute up to $5,500 to an IRA (Traditional, Roth or a combination of both). If you ask your CPA, he or she will most likely tell you to contribute to the Traditional IRA to receive the tax deduction, which will save you approximately $1,375 in federal tax due each tax year, assuming that you are in the 25% tax bracket and you qualify for the full deduction. Let's break down the deduction limits for Roth and Traditional IRAs.
Rules for 2016
If you are also covered by an employer-sponsored retirement plan and are:
-Making less than the $61,000 modified adjust gross income (MAGI) limit, you get the full deduction
-Making between $61,000 and $71,000 MAGI, you get a partial deduction
-Making more than $71,000 MAGI, your Traditional IRA contribution is not deductible
If you are not covered by an employer sponsored retirement plan, the full contribution will be deductible regardless of other factors.
If you make Traditional IRA contributions, you get the tax deduction now and tax-deferred growth on the earnings. When you retire, the full amount withdrawn is taxable as ordinary income.
For example, suppose that you contribute $5,000 per year to a Traditional IRA until you are 63 years old (40 years of saving $5,000 = $200,000) and your Traditional IRA grows to $2,212,962 by the time you hit age 63 (this is possible at a 10% return). Assuming that all your contributions were fully deductible, you saved $50,000 in taxes over the 40 years.
However, now that you are retired, you decide to withdraw $100,000 per year from your Traditional IRA. If you are still in a 25% tax bracket, you will pay $25,000 in income tax on each $100,000 withdrawal each year thereafter. As a result, you net out $75,000 in income per year. (To learn more, read Traditional IRA Deductibility Limits.)
The Roth works differently. Suppose you contribute the same $5,000 per year for 40 years to a Roth IRA. You get no immediate tax deduction, but the Roth IRA still grows to $2,212,962 (assuming a 10% annual return). At age 63, you withdraw $100,000 per year. The difference now is that there is no tax due on the Roth withdrawal, because Roth distributions made after retirement are tax free. In this scenario, you withdraw $100,000 and keep the full $100,000. In this case, the Roth IRA is clearly the best and wisest long-term investment decision for someone this age. (For more insight, see Tax Treatment Of Roth IRA Distributions.)
It depends. Generally speaking a Roth IRA is the best kind of IRA for a 20-something. The reason is the distributions from a Roth IRA are tax free and I am a huge fan of tax free income during retirement. I do not think taxes are going down any time soon. Typically, in your 20's you are in a lower tax bracket and establishing a Roth IRA is the best choice as opposed to a Traditional IRA. With a Traditional IRA the distributions are fully taxable after the age of 59 1/2 however you are able to obtain a tax deduction with your contribution amounts. You need earned income to participate in an IRA and if your modified AGI is above a certain amount you can not make contributions into a Roth IRA.
I typically would recommend the use of a Roth IRA for most people in their twenties when eligible.
A Roth IRA will grow tax-free. That combined with an over 30-year retirement time horizon would allow for significant compounding and growth of the account over time.
It is important to note that Roth IRA eligibility is dictated by one's adjusted gross income annually. You may find that you are not eligible for a Roth IRA contribution if you exceed certain income limits.
As for an investment selection, I might recommend using a low-cost target retirement date fund. Target date funds are a great way to start a foundational investment portfolio. They provide diversification and an appropriate asset allocation. They automatically rebalance and get more conservative as you approach your target retirement date thus simplifying the investment process.
When using target date funds, select a target date that is in line with your projected retirement date. As an example, someone who is 25 with a target retirement at age 60 might select a fund with a target date of 2050. Vanguard offers low-cost target date retirement funds.