Young Investors: Roth IRA or Traditional IRA?

March 8, 2022

Investment Considerations for Your Early Earning Years

Young investors who start saving early can benefit from giving their savings more time to grow. However, it can be difficult to know how to choose between different retirement savings vehicles. In this article, we’ll examine the Roth IRA versus Traditional IRA question and compare and contrast their relative benefits for investors in the early stages of their careers.

The Importance of Using Strategic Investment Vehicles

For a young professional, life is often hectic and full of 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 might be 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.

This couldn’t be further from the truth. It’s during precisely these early earning years when the true impact of your savings is strongest. The sooner you begin investing – any amount at all – the better off you’ll be in the future when you become much more focused on building your retirement nest egg.

A Few Savings Considerations

Socking away as much as you can in the early years of your career 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. That may not always be doable, but remember that even small amounts that are invested early can result in big sums for your retirement savings in the future – and having this long-term focus is important.

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)), the two most common investment vehicles are Traditional IRAs and Roth IRAs.

Traditional Versus Roth IRA for Young Investors

Both Traditional IRAs and Roth IRAs are tax-advantaged accounts, making them good investment options. However, there are key differences to consider when determining which type best fits your needs. Let’s break it down:

Traditional IRA

Contributions grow tax-deferred
Immediate tax-deductibility benefits
Contributions can come from pre-or after-tax dollars
Anyone with earned income can contribute
$6,000 max contribution limit for 2022 ($7,000 for anyone over age 50)

Roth IRA

Contributions grow tax-free
No immediate tax-deductibility benefits
Contributions come from after-tax dollars
Only available to those under certain income levels
$6,000 max contribution limit for 2022 ($7,000 for anyone over age 50)

You can see that both types of investment accounts are useful in retirement planning, but 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 a Roth IRA

Most young investors should opt for a Roth IRA, and it’s due to the benefits of tax-free growth. 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 up front, 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. As a young investor in the early stages of your career, you’re probably enjoying a lower tax bracket than you will in the future with likely job moves and salary increases. Biting the tax bullet at the time of contribution means your dollars can grow tax-free into perpetuity. This means that a Roth IRA offers 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 by then (or if federal tax rates have increased).

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. Even though you’re probably not thinking about your estate plan when you’re young and just starting out, it’s never too soon to begin estate planning and building the legacy you’ll leave to your children and grandchildren.

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 from your account at age 59 ½. So, paying taxes now and contributing after-tax dollars to a Roth likely means you’ll pay less in taxes overall 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.

Overcoming Uncertainty to Make Investment Decisions

As an investor, 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 you can make. 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 as an early saver, you’re at the low end of your lifetime income ladder. 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 an investment advisor will be helpful in plotting your strategy.

At Davidson Capital Management, we provide solutions to help you feel more confident about your future. No matter where you are on your investing journey, we believe you can benefit from our personalized services, which include in-house active investment management. Give us a call today to get the conversation started. After all, it’s never too early to begin planning for a sound financial future.