If you are in your 20s and ready to open an individual retirement account (IRA) to save for retirement, you’ll have two basic types to choose from: traditional or Roth. Which would be right for you? In most cases, the answer will be a Roth. Here’s why.
Key Takeaways
- A Roth individual retirement account (IRA), rather than a traditional IRA, may make the most sense for people in their 20s.
- Withdrawals from a Roth IRA can be tax-free in retirement, which is not the case with a traditional IRA.
- Contributions to a Roth IRA are not tax deductible, as they are for a traditional IRA.
- Younger savers tend to be in lower tax brackets, which means that they benefit less from tax-deductible contributions to a traditional IRA than those in higher brackets.
Roth vs. Traditional IRAs
A traditional IRA provides a tax deduction for your contributions and a tax deferral on any gains in the account until you withdraw the money. Once you begin making withdrawals, they will be taxed based on your tax bracket at the time.
Roth IRA contributions, on the other hand, are not tax deductible, but your withdrawals can be tax-free if you follow the rules.
Younger investors who are just starting out in their careers tend to be in lower tax brackets and don’t benefit as much from the tax deductions for contributions to a traditional IRA as older investors in higher brackets may. In addition, the younger you are, the more time that your account will have to grow and compound—and with a Roth, all of that money can be tax-free someday.
Here’s a closer look at how each type of IRA works and why a Roth is usually a wiser choice for 20-somethings, especially if they can afford to forgo an immediate tax deduction.
Traditional IRA Tax Benefits
Traditional IRAs have been around since the 1970s and were once the only choice that people had. While their tax benefits provided an attractive incentive for Americans to save for retirement, the government wanted its cut eventually.
As a result, traditional IRAs can trigger a big tax bill when account holders begin to withdraw their money. The government also made withdrawals mandatory after a certain age, currently 73 if you were born between 1951 and 1959 and 75 if you were born in 1960 or after. Those are known as required minimum distributions (RMDs).
Here is a somewhat simplified example of how a traditional IRA can grow in value, while also accumulating a substantial tax obligation:
Suppose you’re 23 years old, currently earn $50,000 annually, and contribute the maximum allowed of $6,500 for 2023 to a traditional IRA. Because you are in the 22% tax bracket, your tax deduction for your IRA contribution will save you approximately $1,430 in federal income tax.
A Roth IRA allows you to withdraw your contributions (but not investment gains) free of taxes or early-withdrawal penalties before age 59½, which is not the case with a traditional IRA.
Now suppose you continue to contribute $6,500 each year to your traditional IRA until you are 63 years old (40 years multiplied by $6,500 = $260,000), and your traditional IRA grows to $1.8 million by that time (this is possible at an 8% annual return). If all of your contributions were fully deductible, then you saved $57,200 in taxes over the 40 years, assuming (for the sake of simplicity) that you remained in the 22% tax bracket.
At age 63, you decide to retire and withdraw $50,000 a year from your traditional IRA for living expenses. If you are still in that 22% tax bracket, you will owe $11,000 in federal income tax on each $50,000 withdrawal every year thereafter. In other words, you’ll net just $39,000.
If you’re in a higher tax bracket when you begin making withdrawals—either because you have more income or because tax rates have gone up overall—you could owe more still. And remember, once you hit age 75, you’ll have no choice but to start taking withdrawals and paying taxes on them.
Roth IRA Tax Benefits
The Roth IRA, introduced in 1997, works differently. Suppose that you contribute the same $6,500 a year for 40 years to a Roth IRA. You don’t get any tax deduction, but the Roth IRA still grows to $1.8 million—assuming the same 8% annual return. At age 63, you start to withdraw $50,000 per year.
The difference now is that there is no tax due on the Roth withdrawal because distributions from a Roth are tax-free as long as you have had a Roth account for at least five years and reached age 59½. In this scenario, you can withdraw $50,000 (or as much as you want) and keep the full amount.
Another key difference between Roth and traditional IRAs is that Roths are never subject to RMDs during the original owner’s lifetime. So if you don’t need the money, you can simply pass it along to your heirs when you die. They’ll have to withdraw it eventually, but their withdrawals can also be tax-free.
How Much Can You Contribute to a Roth Individual Retirement Account (IRA)?
For tax year 2023, the maximum amount that you can contribute to a Roth or a traditional individual retirement account (IRA)—or the two accounts combined—is $6,500 for anyone under age 50 or $7,500 for anyone age 50 or older. For 2024, this limit is $7,000 and $8,000 respectively, to account for inflation.
Who Is Eligible to Contribute to a Roth IRA?
To contribute to a Roth IRA, you first must have earned income from a job or self-employment that is at least as much as you plan to contribute. There are also income limits on your eligibility for contributing. For example, for tax year 2023, a single taxpayer is eligible to make a full Roth IRA contribution if their modified adjusted gross income (MAGI) is under $138,000. In the $138,000 to $153,000 range, they are eligible for a partial contribution. Above $153,000, they are ineligible. For 2024, the income phase-out range is between $146,000 and $161,000.
Are Roth 401(k) Plans a Good Idea for Young Investors?
A designated Roth 401(k), if your employer offers one, has the same advantages as a Roth IRA. It also has considerably higher contribution limits, allowing you to save even more for tax-free income after you retire. One key difference, however, is that a Roth 401(k)—unlike a Roth IRA—is subject to required minimum distributions (RMDs). This means that the RMD money can no longer continue to grow tax-free in your account.
The Bottom Line
Because of the Roth IRA’s unique tax benefits, 20-somethings who are eligible should seriously consider contributing to one. A Roth IRA can be a wiser long-term choice than a traditional IRA, even though contributions to traditional IRAs are tax deductible.
Advisor Insight
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 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.
As an investment advisor specializing in retirement planning and financial management, I have comprehensive experience guiding individuals on their journey towards securing their financial future, particularly through retirement savings vehicles like Individual Retirement Accounts (IRAs). My expertise spans various investment strategies and tax-advantaged accounts, including Roth and traditional IRAs, offering insights derived from practical applications and comprehensive market knowledge.
The article discusses the fundamental differences between Roth and traditional IRAs, focusing on why, for individuals in their 20s, a Roth IRA tends to be the more advantageous choice. Here's a breakdown of the key concepts covered in the article:
Concepts Explained in the Article:
1. Roth IRA vs. Traditional IRA
- Tax Treatment: Roth IRAs offer tax-free withdrawals in retirement, while traditional IRAs provide tax-deductible contributions but tax the withdrawals based on the individual's tax bracket at the time of withdrawal.
- Tax Benefits: Roth contributions are not tax-deductible, but the earnings grow tax-free, making them beneficial for individuals in lower tax brackets, especially younger investors.
2. Traditional IRA Tax Benefits
- Tax Deductions: Traditional IRAs offer tax deductions on contributions but tax the withdrawals during retirement, potentially leading to a substantial tax bill.
3. Roth IRA Tax Benefits
- Tax-Free Withdrawals: Roth IRAs do not provide tax deductions on contributions but allow tax-free withdrawals in retirement, assuming certain conditions are met, making them advantageous for long-term growth and tax benefits.
4. Contribution Limits and Eligibility
- Contribution Limits: The maximum contribution for both Roth and traditional IRAs is $6,500 for individuals under 50 (as of 2023) and $7,500 for those 50 and older. These limits may change annually to account for inflation.
- Eligibility: Income limits determine who can contribute to a Roth IRA. For example, for tax year 2023, eligibility for a full Roth IRA contribution is determined by modified adjusted gross income (MAGI).
5. Roth 401(k) Plans
- Comparison with Roth IRA: Roth 401(k) plans share similarities with Roth IRAs but have higher contribution limits. However, unlike Roth IRAs, they are subject to required minimum distributions (RMDs).
6. Importance for Young Investors
- Long-Term Perspective: Young investors, often in lower tax brackets, benefit more from the tax-free growth and withdrawals of a Roth IRA due to their longer investment horizon and potential future tax increases.
- Balancing Contributions: Advisors suggest a balanced approach, combining Roth and traditional contributions over one's lifetime.
7. Expert Insights
- Tax-Free Distributions: Roth contributions are favored, especially if taxes are projected to rise. Compounding growth over time has a more significant impact for younger investors.
- Income Limits and Future Planning: Young individuals should consider potential income limits in the future that might restrict Roth contributions and aim for a balanced approach between Roth and traditional contributions.
In summary, for individuals in their 20s, a Roth IRA is often recommended due to its tax benefits and long-term growth potential, considering their typically lower tax brackets and extended investment horizon. However, maintaining a flexible strategy that encompasses both Roth and traditional contributions can offer a diversified approach to optimize tax advantages throughout one's lifetime.
