A friend recently asked me whether she should open a Roth IRA or a Traditional IRA. In case these terms are unfamiliar to you, IRA stands for Individual Retirement Account—as opposed to a group or company-sponsored type such as a 401(k)—and comes in two main forms: Roth and Traditional.
While the two types of retirement accounts have several minor differences, there’s one major difference between Roth IRAs and Traditional IRAs: tax treatment. With a Roth IRA, you contribute after-tax income. Then, when you’re ready to pull money out later, you don’t pay taxes, since you’ve already paid! However, with a Traditional IRA, you contribute pre-tax income. While this gives you a tax break on your income in the year you contribute, you’re stuck paying ordinary income tax on all the money you pull out at retirement.
Back to my friend’s question. As a financial advisor, my first answer was, “That depends on your goals and risk tolerance.” But as I started to think about it, and as I conducted more research into the differences between the two, I started to gain a preference for the Roth IRA.
Sure, Roth IRAs are not for everyone—no investment vehicle is—but I have concluded that Roth IRAs have four key features that make them particularly well-suited to the needs of young people.
Reason #1: If you’re just getting around to saving for retirement, it may be worth it to pay in your current lower tax bracket.
It might be tempting to want a tax break on your income for contributing money to your Traditional IRA, but saving the bit of money now may not be worth it. The reason for this is that younger people tend to have lower incomes, making the tax deduction received for contributing to a traditional IRA or 401(k) to be of minimal value. Let’s imagine you add $5,000 to a traditional IRA this year. Assuming a 25% tax bracket, you’d save $1,250. That’s a good chunk of change… but $5,000 compounded at a 6% rate of return for 40 years is $51,428. If you pulled this amount out later at the same 25% tax bracket, you’d then owe $12,857. In the words of IRA expert Ed Slott, that’s the equivalent of saying, “Please, Uncle Sam, loan me $1,250 now and I’ll pay you back $12,857 when I retire!”
Because of this lower income early in your career, your earning potential will likely increase over time, and so will your tax rate! Imagine you repeated the example above, only you had to pay a rate of 35% when you retire. In that case, you’d be swapping $1,250 in current tax benefits for a future tax bill of $18,000! That doesn’t sound like a particularly good deal, to me, and that’s not even counting any potential tax rate increases the government might make over the next few decades.
Reason #2: Young people have a longer lifetime during which their Roth IRA contributions can compound tax-free—and that money can grow faster than you’d think.
Thanks to the power of compounding interest, a 30-year-old contributing $5,000 per year for only 10 years could expect to have $396,181.05 in their Roth IRA at age 65. Someone who doesn’t start saving for retirement until 40 or 50 will have a much lower cumulative balance at the end, even though all three scenarios involve $50,000 in total investor contributions.
While this beneficial impact of starting earlier applies to both Roth and Traditional IRAs, the Roth IRA has a slight edge for those investors who can afford to max out their Roth IRA contributions each year. The reason for this is that the maximum contribution to each is the same—$5,500 in 2017—but only one of those investors is stuck paying taxes at retirement! It’s as if more money gets to grow tax free in the Roth IRA structure.
Reason #3: You can technically use a Roth IRA as a savings account or emergency fund.
I can’t in good conscience recommend that people dip into their retirement savings prior to retirement, but if you’re going to have to do it, you’d better hope you’ve got a Roth IRA! The reason for this is that Traditional IRAs have fairly strict rules on early distributions, or money taken out before you turn 59 ½. In fact, you’re stuck paying ordinary income taxes whenever you pull the money out, plus there’s a 10% penalty on top of that, unless you’re taking the money out for something serious such as severe financial hardship or buying your first home.
On the other hand, Roth IRAs feature much more liberal rules about when you’re allowed to pull the money out. Not only do you not have to pay taxes on distributions, but you can avoid the 10% penalty as long as:
- You’re not pulling any investment earnings out of your account (in other words, if you’re just withdrawing your initial contributions)
- It’s been at least five years since your initial contribution to the account.
This means that if you have a lot of money to contribute and/or are extremely secure in the future of your retirement (be careful with this one!!!), you could in theory treat your Roth IRA like a savings account or an emergency fund—but with a far more beneficial interest rate! As such, if you don’t already have a Roth IRA, it might be worth it to open one and start making distributions just to get that five-year countdown started.
Reason #4: The Roth IRA allows for greater flexibility in retirement planning down the line.
If you’re anything like me, retirement seems so far away that it’s hard to plan for. I couldn’t begin to tell you what my actual retirement age will be—all that will depend on how successful my career is, how much I’ve saved up, and how much I still enjoy working decades from now! Luckily, a Roth IRA has several features that allow for greater flexibility in timing your retirement.
First, you can contribute to a Roth IRA at any age, whereas a Traditional IRA only allows you to make contributions until age 70 ½. In fact, once you hit age 70 ½, you are legally required to start taking Required Minimum Distributions from your account! This means you must gradually reduce your IRA balance and add the distributed amount to your income, even if you are not in need of the funds. This feature doesn’t bode well if you find yourself in a scenario where you’re retiring later than expected.
A Roth IRA also has more flexibility when it comes to early retirement. Let’s say you want to retire at age 55. Per the rules discussed in Reason #3, Traditional IRA accounts have much stricter rules about early withdrawals. You’d likely be hit with the 10% penalty if you withdraw your Traditional IRA funds before age 59 ½. With a Roth IRA, on the other hand, you can take advantage of your ability to pull out your original contributions without a penalty, after the five year mark. Having access to penalty-free Roth contributions will help stretch your retirement funds until you can start taking normal distributions from other retirement accounts in the event of early retirement.
Summary: Roth IRA vs. Traditional IRA
I know I hit the benefits of Roth IRAs pretty hard, so in order to present a more balanced analysis of the two, I’ve also compiled their key features in the table below:
Getting Started with Your Roth IRA
If you’ve read through this post and are ready to get started, I encourage you to go for it! “Save early and save often!” tends to be solid advice for investors of all stripes.
That said, if you have questions about opening a Roth IRA, don’t hesitate to reach out. We would love the opportunity to talk to you about your goals and risk tolerance, and figure out a way to help you get started (or get to the next level!) with your retirement savings.
 Calculation assumes a 7% annual rate of return and 0.25% fee ratio on the investments.