For a new college graduate with a good paying first job, do you recommend a Roth IRA or Traditional IRA?
I've heard the positives and negatives on both accounts. Which account makes the most sense if I am in the 25% tax bracket?
Normally, the younger you are and the lower your tax rate, the more the Roth makes sense. This is because there is not much opportunity costs with the lower tax rate and you have decades to compound and make up the difference. Now 25% is fairly high, but if you just graduated and are in your mid-20s, you have decades to make up the difference and I would probably go with the Roth.
One caveat though, everyone assumes the government won't change the laws later. Social security was never supposed to be taxed initially when they "sold" it to everyone (before my time but I study history). So don't assume that the government won't later decide they want to tax Roths EVEN THOUGH you have already paid tax on the monies. If many more younger people do the Roths and that is where the money is, that is what they will tax. The reason the tax code is so convoluted is Congress makes the rules, then taxpayers adjust to pay less in tax, so then Congress goes to & taxes where the money is. Follow the money.
One advantage to the Roth is you can take out contributions at ANY time for ANY reason. It is only the growth that may have penalties or taxes.
In a perfect, just world I would probably do the Roth. And in your situation, I would probably do the Roth anyway. But they aren't mutually exclusive either. So you can do $5,500/yr in either, or in combination. So you could split down the middle as well.
Sorry for the ranting but I wanted you to go into your decision with your eyes open.
Best of luck, Dan Stewart CFA®
This is always an interesting question. I would offer you a nontraditional answer. As a recent college graduate, let's assume you're looking at a 40 year time horizon for the investment of money. Let's further assume that you can make a contribution of $5,000 a year in a 25% tax bracket for the next 40 years. This discussion will not take into consideration inflation. In that 25% bracket you'll save $1,250 each year that you make a $5,000 contribution to the traditional IRA. If we assume a 6% rate of return, that's $193,452 in 40 years. Keep in mind this is the money you would've given to Uncle Sam and no one, including myself, can tell you what tax brackets will be in 40 years or the cost of a loaf of bread. What I can tell you is that this is "found" money and I like using Uncle Sam's money to build for the future. Assume you will put away the same $5,000 for the full 40 years, and continue at 6%, you accumulate a lump sum of $773,000. With this being said, my first recommendation is to take advantage of any 401(k) plan or for a 403-b plan that an employer may offer as in many cases, there is some kind of a match that you don't get with the traditional IRA or Roth IRA. Then consider 2 to 3 years of a Roth contribution which will allow for the tax-free accumulation of not only dividends and interest, but capital gains which over a long period of time can be extremely beneficial. Then, to the extent you have any room left to make additional contributions only then would I make a contribution to a traditional IRA. Opinions on the subject are going to be all over the lot. However Hope this helps and good luck.
Investing through a Roth IRA is really a bet that your tax rate will be higher in retirement than it is right now. With a Traditional IRA you get a tax deduction now, but the government will always own a piece of your IRA. The size of that piece is whatever tax bracket you're in after retirement, and the IRS will want its money back whenever you withdraw funds. If your tax rate today is the same as it will be in retirement, the difference between the two is essentially a wash. With a Roth IRA you don't get a tax deduction now, but any withdrawals after age 59 1/2 are tax-free. There may be some benefit to having a tax-free bucket of money you can access after retirement. If you expect your income to increase throughout your career, tax deductions will probably be more valuable in the future than they are now. Another consideration for new college graduates is that your contribution to a Roth IRA can be taken back out without taxes or penalties. This isn't the case with a Traditional IRA, so contributing to a Roth IRA early gives you some more flexibility.
Since you are young and in a relatively low (or average) tax bracket, you should consider a Roth IRA. This will allow you to take advantage of tax-free growth and qualified withdrawals. If you have a company plan with employer matching, you should meet that contribution. Any surplus after funding your Roth IRA ($5,500/year) can go in an individual taxable account for general purpose investing.
Before even confronting the IRA question, address the issue of whether your "good paying first job" offers a 401(k) with a company match of any kind. If it does, then contribute as much as is required to generate that full match. This has the same effect as earning a guaranteed 100% on your investment, something not available in an IRA or anywhere else.
Once you have figured that out, I would recommend evenly splitting your likely allowable contribution of up to $5500 per year between a Roth IRA and a Traditional IRA. Giving yourself this diversity of tax structures while you are able to will help you when it comes to taking distributions in retirement.
You'll read elsewhere that if you make this assumption about your current tax rates vs some other assumption about future tax rates that you should come down on one side or the other. Sure, if you were in the 10% tax bracket, I'd tell you to lean more towards a Roth. But at 25% and with no clue as to what tax rates or income expectations are decades in the future, don't bother going through this exercise in guesswork.
Sooner or later, it is possible that you will earn too much to benefit from a tax deduction to a Traditional IRA and may be forced into making Roth only contributions. And at some point, you may earn too much to contribute to a Roth at all. So I believe it makes sense early in your career, while both options are available to you, to contribute to both.