It's never too early to start thinking about retirement, and recent college graduates and others new to the workforce should be considering establishing an individual retirement savings plan. However, they must decide between a traditional individual retirement account (IRA) and a Roth IRA. The essential difference between these accounts is whether taxes are paid now, as with an Roth IRA, or after you retire, as with a traditional IRA.
The main factor affecting a young investor’s IRA choice are the income levels and tax rates expected at retirement. Those expectations determine whether it would be better off paying taxes on retirement savings now or waiting until retirement to pay the taxes. If you anticipate that your income and corresponding tax rate will be high in retirement, you may be better off with the tax-free income offered by a Roth IRA. But if you expect much lower income and a correspondingly low tax rate in retirement, a traditional IRA could be to your benefit. This is because it will give you a tax deduction throughout your working life, with a relatively mild tax bite in retirement.
Young adults who are new entrants in their field will be at the bottom of the occupational pay scale and in a relatively low tax bracket. The tax-deductible contributions of a traditional IRA may not mean much when your tax bills are relatively small. If you anticipate higher taxes in future you may want to act now to lock in a tax-free income stream for your retirement by opening a Roth IRA. Another Roth benefit is that earnings won’t be taxed if you keep them in the account until you reach retirement age. You can put up to $5,000 annually into a Roth account if your income is below $105,000 if single, or $167,000 if married filing jointly.
A traditional IRA allows you to take a tax deduction on the contributions you make to your retirement plan each year. The tax deduction effectively time-shifts the taxes on your contributions and any earnings on those contributions from now to when you retire. With a traditional IRA you can deduct up to $5,000 of contributions annually. That deduction can cut hundreds of dollars off your tax bill each year. But your tax deduction for traditional IRA contributions will be reduced if you or your spouse is covered by a 401k or other employer-sponsored retirement plans during your working lifetime.
The choice between a Roth IRA and traditional IRA isn’t mutually exclusive. You can contribute to both types of account in the same year. You can open a Roth account with after-tax income early in your career to ensure tax-free income late in life. In later years, you can open a traditional IRA to take advantage of the tax deduction on contributions. The only drawback to this strategy is that the $5,000 annual limit on IRA contributions applies to all IRAs you have open. For example, if you contributed $4,000 to your traditional IRA, that means you could only contribute $1,000 to your Roth account.
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