Each individual investor will have different preferences for their IRA, but using a Traditional IRA might not be the best option as a young person. Although it is what your parents are familiar with and maybe even what your financial advisor recommends, 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 2019, you can contribute up to $6,000 to an IRA (Traditional, Roth or a combination of both). 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 $1,375 in federal tax due each tax year, assuming that you are in the 25% tax bracket and you 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 When you retire, the full amount withdrawn is taxable as ordinary income.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 $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.
Stephen Rischall, CFP, CRPC
Navalign Wealth Partners, Encino, CA
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 which 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 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.
The Bottom Line
Due to the retirement benefits, 20-something-year-olds should seriously consider placing their funds in a Roth IRA. The Roth is considered a wiser long-term investment choice, even with the tax deductions of a Traditional IRA.