Traditional or Roth?
If you are considering opening an IRA and are a 20-something, you are ahead of the pack. But be aware that the unique tax benefits of a Roth IRA may make it a better option for younger savers than a traditional IRA.
Roth IRA contributions are not tax-deductible, but both gains and withdrawals are tax-free. Younger investors starting out in their careers tend to be in lower tax brackets and don't benefit as much from the tax deductions from contributions to a traditional IRA. What's more—as will be obvious shortly—with decades until retirement, you will benefit hugely from not being taxed on all the compounded earnings your savings will garner by the time you withdraw them.
- While traditional and Roth IRAs both offer a tax-advantaged way to save for retirement, a Roth may make the most sense for 20-somethings.
- Withdrawals from a Roth IRA are tax-free in retirement, which is not the case with a traditional IRA.
- Contributions to a Roth are not tax-deductible, but they are for a traditional IRA.
- Because younger savers tend to be in lower tax brackets, they benefit less from tax-deductible contributions to a traditional IRA.
Here's a deeper look at how each works and why a Roth IRA is a wiser choice for 20-somethings who are just starting to save for retirement.
Traditional IRA Tax Benefits
Although a traditional IRA is what your parents are likely to be familiar with, and maybe even what your financial advisor recommends (if you have one), there is a significant tax hit when you withdraw in retirement.
Suppose that you are 23, you've been working for a couple of years and are now earning $50,000 per year. For 2020, you can contribute up to $6,000 to an IRA (traditional, Roth, or a combination of both).
Another benefit of a Roth IRA is that contributions (not investment gains) can be withdrawn penalty free before age 59½, which is not the case with a traditional IRA.
If you ask your CPA, they will most likely tell you to contribute to the traditional IRA to receive the tax deduction, which will save you approximately $1,320 in federal tax due each tax year, assuming that you are in the 22% tax bracket and qualify for the full deduction.
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 When you retire, the full amount withdrawn is taxable as ordinary income.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 $6,000 per year to a traditional IRA until you are 63 years old (40 years of saving $6,000 = $240,000) and your traditional IRA grows to $1.6 million by the time you hit age 63 (this is possible at an 8% annual return). Assuming that all your contributions were fully deductible, you saved $52,800 in taxes over the 40 years, assuming you remain in the 22% tax bracket.
However, now that you are retired, you decide to withdraw $50,000 per year from your traditional IRA. If you are still in the same tax bracket, you will pay $11,000 in federal income tax on each $50,000 withdrawal every year thereafter.
Roth IRA Tax Benefits
The Roth works differently. Suppose you contribute the same $6,000 per year for 40 years to a Roth IRA. You get no immediate tax deduction, but the Roth IRA still grows to $1.6 million (assuming the same 8% annual return). At age 63, you withdraw $50,000 per year.
The difference now is that there is no tax due on the Roth withdrawal, because distributions made after retirement are tax-free. In this scenario, you withdraw $50,000 and keep the full amount. In this case, the Roth IRA is clearly the best and wisest long-term decision when you're in your 20s.
Stephen Rischall, CFP, CRPC
Navalign Wealth Partners, Encino, Calif.
In general, Roth contributions have an edge over traditional contributions for young people. Having tax-free distributions in retirement is great, especially if taxes go up in the future. Since younger investors have a longer time horizon, the impact of compounding growth benefits even more.
Most young people tend to be in lower tax brackets. The benefit of deferring taxes by making contributions to a traditional IRA may not have as much of a tax savings impact as it will in the future when you are earning more.
There are income limits that disqualify you from making Roth IRA contributions. One day if your income surpasses that limit, you can't add to it.
Ultimately, you should seek a balance of making both Roth and traditional contributions over your lifetime.
The Bottom Line
Due to the tax benefits of Roth IRAs, 20-somethings should seriously consider contributing to one. The Roth can be a wiser long-term choice, even though contributions to a traditional IRA are tax deductible.