The Best IRA for a 20-Something Investor

If you’re in your 20s and want to open an IRA, consider yourself lucky because you’re ahead of the pack. But be aware that the unique tax benefits of a Roth IRA may make it a better option for younger savers than a traditional IRA.

A traditional IRA provides a tax deduction on contributions and tax deferral on any gains. Withdrawals are taxed based on your income tax bracket when you retire. Roth IRA contributions are not tax-deductible, but both gains and withdrawals are tax-free in retirement.

Younger investors starting out in their careers tend to be in lower tax brackets and don’t benefit as much from the tax deductions from contributions to a traditional IRA. And don’t forget, you’ll benefit hugely from not being taxed on all the compounded earnings your savings will garner by the time you withdraw them since you will be decades from retirement.

Here’s a deeper look at how each works and why a Roth IRA is a wiser choice for 20-somethings who are just starting to save for retirement.

Traditional IRA Tax Benefits

Although a traditional IRA is what your parents are likely to be familiar with, and maybe even what your financial advisor recommends (if you have one), there is a significant tax hit when you withdraw in retirement.

Suppose that you are 23, you’ve been working for a couple of years and now earn $50,000 per year. For 2021 and 2022, you can contribute up to $6,000 to an IRA (traditional, Roth, or a combination of both). Your accountant will probably tell you to contribute to the traditional IRA to receive the tax deduction, which will save you approximately $1,320 in federal tax due each tax year, assuming that you are in the 22% tax bracket and qualify for the full deduction in 2021.

If you are not covered by an employer-sponsored retirement plan, the full contribution is deductible regardless of other factors. If you make traditional IRA contributions, you get the tax deduction now and tax-deferred growth on the earnings. When you retire, the full amount withdrawn is taxable as ordinary income.

For example, suppose that you contribute $6,000 per year to a traditional IRA until you are 63 years old (40 years of saving $6,000 = $240,000), and your traditional IRA grows to $1.6 million by the time you hit age 63 (this is possible at an 8% annual return). Assuming that all your contributions were fully deductible, you saved $52,800 in taxes over the 40 years, assuming you remain in the 22% tax bracket.

But now that you are retired, you decide to withdraw $50,000 per year from your traditional IRA. If you are still in the same tax bracket, you will pay $11,000 in federal income tax on each $50,000 withdrawal every year thereafter.

Roth IRA Tax Benefits

The Roth works differently. Suppose you contribute the same $6,000 per year for 40 years to a Roth IRA. You get no immediate tax deduction, but the Roth IRA still grows to $1.6 million—assuming the same 8% annual return. At age 63, you withdraw $50,000 per year.

The difference now is that there is no tax due on the Roth withdrawal, because distributions made after retirement are tax-free. In this scenario, you withdraw $50,000 and keep the full amount. In this case, the Roth IRA is clearly the best and wisest long-term decision when you’re in your 20s.

The Bottom Line

Due to the tax benefits of Roth IRAs, 20-somethings should seriously consider contributing to one. The Roth can be a wiser long-term choice, even though contributions to a traditional IRA are tax-deductible.