Why Young Investors Should Choose Roth Over Traditional IRAs
Savings Considerations for Your Early Earning Years
When it comes to investing, an earlier start means your retirement savings will have more time to grow and you can take full advantage of the magic of compounding. However, many young investors find it challenging to truly focus on saving for retirement, let alone get choosy about the different savings vehicles like Roth IRAs or Traditional IRAs. After all, life is often full of hectic changes and transitions, both at work and personally. If you’re a young investor, you’re in your early earning years when potential job mobility is high, and you’re probably focused on things like buying a home, getting married, and having children. Even if you do find the time and resources to put a bit away for retirement in the midst of all this, you may not believe it’s enough to require a meaningful tax strategy.
Of course, the opposite is true. It is during those early earning years when the true impact of your savings is strongest. The sooner you begin saving – any amount at all – the better off you’ll be in the future when you become much more focused on building your nest egg for retirement.
The amount you’re able to save in these early years is certainly important. To the extent you’re able to, you should try to maximize employer matches of “free” money and max out your own contributions when possible. Of course, this isn’t always doable, but it’s important to remember that even small amounts that are invested early can result in big sums for your retirement savings in the future.
Regardless of the amount you’re able to put away as a young investor, you’ll want to be strategic with it so that you can be as tax-efficient as possible. Outside of your employer-sponsored retirement plan (typically a 401(k) or 403(b) plan), the two most common investment vehicles are Traditional IRAs and Roth IRAs. While both are useful in retirement planning, there is one big difference: any contributions you make to a Traditional IRA won’t be taxed until you start withdrawing money from the account down the road, while contributions to a Roth IRA are taxed upfront and, thus, grow tax-free into the future.
Why Young Investors Should Choose Roth
If you assume a constant marginal tax rate, young investors are better off utilizing a Roth IRA. This may seem counterintuitive since Traditional IRAs offer a tax break upfront, but here’s why:
If you’re going to pay tax upfront on contributions, as is required for a Roth IRA, you want to do it when you’re in a lower tax bracket. Most young investors are enjoying lower tax brackets than they will in the future with likely job moves and salary increases on the horizon. Biting the tax bullet at the time of contribution means your dollars can grow tax-free into perpetuity. This means that a Roth IRA will also offer you the benefit of tax-free income once you retire, so you won’t have to worry if you’re in a higher tax bracket at that point.
Another notable benefit of a Roth IRA is that there are no Required Minimum Distributions (RMDs) in your lifetime, unlike the Traditional IRA. This means your wealth can continue to grow, making Roth accounts ideal for future wealth transfers. Though you may not be thinking about your estate plan when you’re young and just starting a family, it’s never too soon to begin estate planning and building the legacy you’ll leave to your children and grandchildren.
An additional benefit of Roth IRAs for young investors is that you can contribute at any age (as long as you have earned income), though income limits may mean at some point you’ll need to utilize a Backdoor Roth IRA to accomplish your tax-efficient savings goals.
Predicting Your Tax Future
As mentioned above, Roth IRAs are absolutely beneficial if you’re a young earner because you are likely in a lower marginal tax bracket than you’ll find yourself in when you can begin withdrawing at age 59 ½. So, paying taxes now and contributing after-tax dollars to a Roth likely means you’ll pay less in taxes than you would if you contributed the same amount pre-tax to a Traditional IRA and had to pay taxes on your withdrawals later in life when the tax rate would likely be higher.
Of course, it’s impossible to predict what tax rates will look like 30 or 40 years from now. It’s also impossible to know what your taxable income will look like in retirement, which would determine your tax rate. Your filing status could change by then, too, meaning there are lots of reasons why you can’t know for certain that you’ll be in a higher tax bracket when you retire than you are as a young earner right now.
Consider the recent past: In the 1980s, the federal deficit in the United States reached 5.7 percent of GDP – the worst level in 40 years. Most people predicted that taxes would rise, yet the highest tax bracket actually fell from 50 percent to 37 percent, where it stands today. Though our deficit is once again quite high, it’s actually a poor indicator of where our tax rates could end up in thirty years.
Overcoming Uncertainty to Make Investment Decisions
When it comes to long-term savings, investment, and tax strategy, you’ll have to make a certain amount of your decisions under conditions of significant uncertainty. Tax policy and the stock market are unpredictable, but there are still some reasonable assumptions that can be made. For instance, it’s reasonable to assume that tax rates will continue to be progressive, meaning higher incomes are taxed at higher rates. That likely means that, as an early saver, you’re at the low end of your lifetime income ladder. So, making contributions to your Roth IRA for as long as you’re in a lower tax bracket makes sense.
Once you reach an income level that puts you in one of the higher tax brackets, you should probably switch to contributing to a Traditional IRA instead. Of course, it can be complex to determine what’s best for your individual circumstances, so speaking with a financial advisor will be helpful in plotting your strategy no matter where you are in your financial journey.
At FC Wealth, we strive to help individuals and families find confidence in their financial futures and the freedom to lead fulfilled lives. If you’re ready to begin a conversation about your long-term strategy, contact us today. It’s never too early to begin planning for a sound financial future, and we look forward to serving you.