Being that I am a 24 year old Financial Advisor, I feel it is my responsibility to make the case for starting a Roth IRA in your 20s versus a Traditional IRA. Let’s first start with a quick distinction between the two very similar and often confused retirement vehicles.
For 2015, your total contributions to all of your traditional and Roth IRAs cannot be more than:
$5,500 ($6,500 if you’re age 50 or older), or
Your taxable compensation for the year, if your compensation was less than this dollar limit.
Both may be subject to a 10% penalty on distributions withdrawn before 59 1/2 ; years old.
Beginning with a Traditional IRA, all contributions are tax-deductible and those contributions grow tax-deferred.
Tax-deferred growth simply means that an individual would not have to pay taxes on any capital gains, interest or dividends produced from a Traditional IRA UNTIL that individual decides to take a distribution. Assuming the individual takes a distribution after the age of 59 1/2, that distribution is now taxed at their ordinary income rate. Let’s look at the following example:
Twenty-five year old Johnny Bravo makes 50k a year and contributes the max contribution of $5,500 to his Traditional IRA in 2015. Because that $5,500 is tax deductible Johnny is taxed as if he made $44,500 in 2015.
Let’s assume he makes no further yearly contributions for the rest of his life and that initial $5,500 contribution grows tax-deferred for 40 years at 5%. Johnny is now 65 and his Traditional IRA is worth $38,719.94 and decides to take the entire $38,719.94 out. Johnny will be taxed on the $33,219.94 in gains at his current ordinary income rate. Let’s assume his tax rate is currently 20% in which he will have to pay $6,643.98 in taxes on the $38,719.94 in gains. This will net him a final distribution of $30,975.95 after taxes.
Hopefully I didn’t lose you because we are going to run that same example, however this time with Johnny Bravo utilizing a Roth IRA. But first, I want you to think of the Roth IRA as almost the inverse to the Traditional IRA in regards to taxation. Any contributions made to a Roth IRA are NOT tax-deductible. However, just like the Traditional IRA, those contributions now grow tax-deferred. Now on the back end, or when an individual decides to take a distribution, those dollars now come out TAX FREE assuming you have owned the account for at least five years.
So essentially you paid the taxes upfront (by not taking the deduction) for those dollars to come out tax free in the end. Let’s run it through the same example with the same assumptions as before:
Twenty-five year old Johnny Bravo makes 50k a year and contributes the max contribution of $5,500 to his Roth IRA in 2015. Because that $5,500 is NOT tax deductible Johnny is taxed as if he made $50,000 in 2015.
Let’s assume he makes no further yearly contributions for the rest of his life and that initial $5,500 contribution grows tax-deferred for 40 years at 5%. Johnny is now 65 and his Traditional IRA is worth $38,719.94 and decides to take the entire $38,719.94 out. Johnny will NOT be taxed on the $33,219.94 in gains which will net him a final distribution of $38,719.94.
As you can see Johnny has netted a far greater amount of money with the ROTH than the Traditional IRA. So what’s the catch??
Well what you have to compare is the amount of money Johnny would have saved in taxes if he took the $5,500 deduction in 2015. Basically if he would have saved more than $6,643.98 in taxes in 2015 by taking the $5,500 deduction then the Roth would be the worse deal.
Another very important argument is what the tax rates will be in the future. In the Traditional IRA example we assumed the future ordinary income rate for Johnny was 20%. Well what if 40 years from now, the tax brackets have dramatically changed and Johnny’s tax rate is now 40% when he decides to take a distribution? That means (using the above Traditional IRA example) he would have had to pay $13,287.96 in taxes netting a final distribution of $23,231.96. This clearly makes the Roth IRA an even Better option. A Roth is a great way to eliminate the unknown that is your future tax rate. You are effectively paying the taxes TODAY on your future retirement account by not taking a deduction.
The Roth tends to be the better option for younger people I.E people in their 20’s. The reason being that a twenty-something has more TIME for the money to grow. That way the money saved in taxes when taking the future distribution far out-weighs the money saved today by taking the deduction.
If you are in your twenties, utilize the most valuable asset you have – TIME. This is why a Roth IRA may be the best option for a twenty-something.
Raymond James Financial Services, Inc.
This advice may not be suitable for everyone. Changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Unless certain criteria are met, Roth IRA owners must be 59 1/2; or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. The examples above are for illustrative purposes only. Actual investor results will vary.