All of the above answers are great. Too many individuals rely solely on taxable income during retirement. One other benefit to a Roth IRA, your contributions can be taken out at any time - without penalty. This is because they are after-tax contributions. Now, I don't recommend that my clients use this strategy often because a Roth IRA should be earmarked for retirement. But it is a nice thing to know. I've had clients that decide to retire at 50 that make it through their first few years of retirement on their Roth IRA contribution amounts until they can tap into their other asset pools. Roth IRA's are just very flexible.
Making the assumption that your current income level allows for a Roth IRA contribution it is usually more beneficial for a 20-something to contribute to a Roth IRA.
Remember the difference between a Traditional IRA and a ROTH IRA.
Traditional IRA is pretax dollars contributed (you have not paid income taxes on those funds) all gains grow tax free but when you withdraw the funds the taxes are then paid as if it were income.
A ROTH IRA is after tax dollars contributed (income taxes were paid already) and then all gains are tax free and any withdrawals are tax free (assuming all proper withdrawal rules are followed).
So it is important to consider two things:
- What is my tax rate now?
- What will be my tax rate at retirement?
The assumption in this scenario is that your income level will be higher when you retire than it is now therefore, you paid less tax on the money.
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.
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.
The best type of IRA will depend on whether you’re taking advantage of a 401(k) plan at work. If you are able to contribute to your 401(k) at work and you earn less than $117,000, if you are single ($184,000 for married couples), I would suggest opening and contributing to a Roth IRA.
Here’s why: If you are already contributing to a 401(k), then contributing to a traditional IRA has little tax benefit to you. If you were to make an IRA contribution, the contribution would be in after-tax dollars and the funds would grow tax deferred, but the distributions would be partially taxable. In contrast, if you were to follow my suggestion and contribute to a Roth IRA, the funds within the Roth IRA would grow tax free and distributions are tax free.
If you do not have a 401(k) plan at work that you can contribute to, then there are a couple of pros and cons to both IRA and Roth IRA contributions. First, you can only make a maximum contribution of $5,500 to either or both types of IRAs in one year. The main benefit of contributing into an IRA when you do not have a 401(k) at work is that your contribution reduces your taxable income. Once you make your contribution, the funds will grow tax deferred and distributions once you surpass age 59.5 are taxable (the same as with a 401(k) contribution). If you were to contribute to a Roth IRA instead, the contribution would not decrease your taxable income, but the funds would grow tax free and distributions are tax free once you surpass 59.5 years of age.