What's the best kind of IRA for a 20-something?
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.
Thank you for your question. Essentially you have two types of IRA's to choose from. A Traditional IRA and a Roth IRA. They both allow you to save for retirement, the difference being that the Traditional is funded with pre-tax dollars, the Roth is funded with after-tax dollars. Which one is right for you? It depends on your financial situation and what you are looking to accomplish for the future.
Something to consider is that, historically speaking, income tax rates are about the lowest they have ever been. Given this tax environment, one could make the argument that taxes will most likely be higher in the future, thus funding a Roth IRA for a younger person in their 20's would seem to make sense. Keep in mind you can actually have both IRA's, as long as your total funding between both does not go over the annual IRA limit.
It really all comes down to your unique situation, I would encourage you to meet with a CFP and Tax professional to make sure you set up what is best for your situation.
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.)
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.
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.