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 $6,000 for 2022 to a traditional IRA. Because you are in the 22% tax bracket, your tax deduction for your IRA contribution will save you approximately $1,320 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 $6,000 each year to your traditional IRA until you are 63 years old (40 years multiplied by $6,000 = $240,000), and your traditional IRA grows to $1.6 million by that time (this is possible at an 8% annual return). If all of your contributions were fully deductible, then you saved $52,800 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 $6,000 a year for 40 years to a Roth IRA. You don’t get any tax deduction, but the Roth IRA still grows to $1.6 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 2022, the maximum amount that you can contribute to a Roth or a traditional individual retirement account (IRA)—or to the two accounts combined—is $6,000 for anyone under age 50 or $7,000 for anyone age 50 or older. For 2023, this limit is $6,500 and $7,500 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 2022, a single taxpayer is eligible to make a full Roth IRA contribution if their modified adjusted gross income (MAGI) is under $129,000. In the $129,000 to $144,000 range, they are eligible for a partial contribution. Above $144,000, they are ineligible. For 2023, the income phase-out range is between $138,000 and $153,000.
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.
FAQs
The Best IRA for a 20-Something Investor? ›
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.
What kind of IRA should a 20 year old have? ›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.
Should a 20 year old open a Roth IRA? ›However, there are tremendous advantages to making Roth IRA contributions a priority at a young age. First of all, the small amounts saved when people are in their twenties have time to grow and take advantage of compounding. Compounding is when earnings and interest earned on a deposit accumulate and are reinvested.
How much can an IRA make in 20 years? ›You will save $148,268.75 over 20 years. Your actual qualifying contribution may differ significantly from the amounts listed above (for reasons such as income, filing status, employer benefits, and more). We strongly recommend that you consult your tax advisor before contributing to a retirement program.
What is the best IRA to go with? ›Retirement experts often recommend the Roth IRA, but it's not always the better option, depending on your financial situation. The traditional IRA is a better choice when you're older or earning more, because you can avoid income taxes at higher rates on today's income.
Should a 19 year old open a Roth IRA? ›Roth IRAs are a good choice for young adults because at this point in your life you're probably in a lower tax bracket (find out your bracket here) than you will be when you retire. A great feature of the Roth IRA for young people is that you can withdraw your contributions anytime and without taxes or penalties.
At what age does a Roth IRA not make sense? ›There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.
How to start a retirement fund at 20? ›- Start saving today. You can probably find plenty of reasons not to save money. ...
- Sign up for your employer's 401(k) If you're eligible to participate in a 401(k) at work, do so. ...
- No 401(k)? ...
- Be aggressive with your investments. ...
- Build an emergency fund.
Start by opening an account with $1,000. From there, see if you can add in an additional $2,000 by the end of the year. That gives you a starting balance of $3,000 by your 26th birthday. We'll assume, at this point you start maxing out your IRA by depositing $541 per month ($6,500 a year) and earning an average of 10%.
How much can a 21 year old put in a Roth IRA? ›How much can I contribute? The most you can contribute to all of your traditional and Roth IRAs is the smaller of: For 2021, $6,000, or $7,000 if you're age 50 or older by the end of the year; or your taxable compensation for the year.
Can you make a million from an IRA? ›
Amassing $1 million in your Roth IRA is a long-term game. The earlier you start, the more time you'll have to reach your goals. If you start your Roth IRA journey in 2022, you can make consistent contributions and max out your account every year to get you to the million-dollar mark.
How fast does IRA grow? ›Historically, with a properly diversified portfolio, an investor can expect anywhere between 7% to 10% average annual returns. Time horizon, risk tolerance, and the overall mix are all important factors to consider when trying to project growth.
What salary is too high for IRA? ›No, there is no maximum traditional IRA income limit. Anyone can contribute to a traditional IRA. While a Roth IRA has a strict income limit and those with earnings above it cannot contribute at all, no such rule applies to a traditional IRA. This doesn't mean your income doesn't matter at all, though.
Which is better Vanguard or Fidelity? ›Bottom Line. Overall, Vanguard and Fidelity are both great choices for those interested in investing. They offer a wide range of investment options, low costs, and hands-off or active management depending on your preference. When it comes to index funds, Vanguard is hard to beat, with hundreds of low-cost options.
What is the safest IRA to have? ›| Company | Forbes Advisor Rating | Annual advisory fee |
|---|---|---|
| TD Ameritrade | 4.3 | - |
| Betterment | 4.8 | 0.25% |
| Vanguard Digital Advisor | 4.8 | No more than 0.20% |
| SoFi Automated Investing | 4.7 | $0 |
IRA drawbacks
One drawback of using IRAs to save for retirement is that the annual contribution limits are relatively low. In 2022, you can contribute up to $20,500 to a 401(k) plan, but you can only contribute $6,000 to an IRA (the limit goes up to $7,000 if you're at least 50 years old).
Assuming an annual January contribution to your Roth IRA of $6,500 and an 8% average long-term investment return, you can expect to become an IRA millionaire in just under 34 years.
How a kid can be a millionaire with a Roth IRA? ›Unlock the possibilities of a $1 million Roth IRA
This is possible because anyone can contribute to a Roth IRA, so long as they have earned income for the year. You're allowed to contribute up to $6,000 to a child's Roth IRA or 100% of the child's earned income for 2022, whichever is less.
The Bottom Line. In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.
Who Cannot invest in Roth IRA? ›If your earned income is too high, you cannot contribute at all. Modified AGI (MAGI) income limits on Roth IRA contributions for the 2023 tax year are $153,000 ($144,000 in 2022) for single filers and $228,000 ($214,000 in 2022) for married couples filing jointly.
How much money do you need to start a Roth IRA? ›
What is the minimum to open a Roth IRA? The good news is that the IRS doesn't require a minimum amount to open a Roth IRA. While there's a Roth IRA maximum contribution amount, there's no minimum, according to IRS rules.
How much should I put in my Roth IRA per month? ›The maximum amount you can contribute to a traditional IRA or Roth IRA (or combination of both) in 2023 is capped at $6,500. Viewed another way, that's about $542 a month you can contribute throughout the year. If you're age 50 or over, the IRS allows you to contribute up to $7,500 annually (or $625 a month).
What should a 20 year old invest in for retirement? ›- Invest in the S&P 500 Index Funds.
- Invest in Real Estate Investment Trusts (REITs)
- Invest Using Robo Advisors.
- Buy Fractional Shares of a Stock or ETF.
- Buy a Home.
- Open a Retirement Plan — Any Retirement Plan.
- Pay Off Your Debt.
- Improve Your Skills.
Knowing how much to save for retirement in your 20s is a very personal question for every individual and will depend on their job, their expenses, and any other obligations they may have. In general, it is a good idea to save 10% to 15% of your income, but even saving less is better than not saving at all.
How much should a 20 year old invest in 401k? ›Including your employer's match, you should aim to save 15% of your pre-tax income a year as you move toward your late 20s and start earning more money. Even if you can't reach the 15% target, the Thrivent financial services group recommends trying to boost your retirement contributions by 1% to 2% each year.
Is it better to invest weekly or monthly? ›Their rough math showed that for the amounts they invest, they would have 8.4% more invested after a ten-year period, just by investing weekly rather than monthly. In their situation, this could amount to >$86,000 in ten years!
What age should you open an IRA? ›Prime Working Years (35 to 60)
This is when people typically start thinking about opening an IRA and with good reason. You're in your prime earning years, so you likely have the money to tackle this goal. At this stage of your life, it's generally a good idea to start saving as much as possible for retirement.
So to answer the question, we believe having one to one-and-a-half times your income saved for retirement by age 35 is a reasonable target. By age 50, you would be considered on track if you have three to six times your preretirement gross income saved.
Can I max out my child's Roth IRA? ›IRA contributions cannot exceed a minor's earnings, e.g., if a minor earns $1,000, then only $1,000 can be contributed to the account. There's an annual maximum contribution of $6,000 per child, per year for 2022 and $6,500 per year for 2023.
How much can a single person put in a Roth IRA in 2023? ›The Roth IRA contribution limit for 2023 is $6,500 for those under 50, and an additional $1,000 catch up contribution for those 50 and older. Source: "Retirement Topics—IRA Contribution Limits," Internal Revenue Service, Dec 21, 2022.
How many times a year can I withdraw from my IRA? ›
Frequently Asked Questions
Generally, the limitation on withdrawing funds from an IRA is one withdrawal per year. In addition, taxes and penalties may be associated with taking money out before age 59 1/2.
In general, if you think you'll be in a higher tax bracket when you retire, a Roth IRA may be the better choice. You'll pay taxes now, at a lower rate, and withdraw funds tax-free in retirement when you're in a higher tax bracket.
What is a good age to start an IRA? ›Prime Working Years (35 to 60)
This is when people typically start thinking about opening an IRA and with good reason. You're in your prime earning years, so you likely have the money to tackle this goal. At this stage of your life, it's generally a good idea to start saving as much as possible for retirement.
The Bottom Line. In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.
Should I get a Roth IRA or a traditional IRA? ›A Roth IRA or 401(k) makes the most sense if you're confident of having a higher income in retirement than you do now. If you expect your income (and tax rate) to be higher at present and lower in retirement, a traditional IRA or 401(k) is likely the better bet.
What are the 3 types of IRA? ›- Traditional IRA. Contributions typically are tax-deductible. ...
- Roth IRA. Contributions are made with after-tax funds and are not tax-deductible, but earnings and withdrawals are tax-free.
- SEP IRA. ...
- SIMPLE IRA.
IRA contributions after age 70½
For 2020 and later, there is no age limit on making regular contributions to traditional or Roth IRAs.
An IRA not only gives you the ability to save even more, it might also give you more investment choices than you have in your employer-sponsored plan. And if you have a Roth IRA, there's also the potential for tax-free income down the road.
Is it too late to start an IRA at 30? ›It's never too late to start saving money for your retirement. Starting at age 35 means you have 30 years to save for retirement, which will have a substantial compounding effect, particularly in tax-sheltered retirement vehicles.
Should I max out my 401k or Roth first? ›If you don't have enough money to max out contributions to both accounts, experts recommend maxing out the Roth 401(k) first to receive the benefit of a full employer match.
How much does a Roth IRA earn annually? ›
Roth IRAs are a popular retirement account choice for a reason. It's because they're easy to open with an online broker and historically deliver between 7% and 10% in average annual returns. Roth IRAs harness the advantages of compounding, which means even small contributions can grow significantly over time.
How many Roth IRAs should I have? ›What's the right number of IRAs? For most people, the number is at least two: Both a Roth and traditional IRA, in addition to a workplace retirement plan such as a 401(k), if you've got one.
What is one negative to a Roth IRA? ›One disadvantage of the Roth IRA is that you can't contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status.
Should I open an IRA with my bank? ›Bank IRAs are ultra-safe investments. If you open one at a Federal Deposit Insurance Corporation (FDIC)-accredited institution, the funds you save in an IRA savings account or IRA CD receive deposit insurance up to the legal limit. Even if the bank were to fail, you wouldn't lose the funds saved in your IRA.
What is the 5 year rule for Roth IRA? ›The 5-year rule on Roth conversions requires you to wait five years before withdrawing any converted balances — contributions or earnings — regardless of your age. If you take money out before the five years is up, you'll have to pay a 10% penalty when you file your tax return.