If you're young and saving for retirement, it's "not even a question" which type of investment account you should choose, says IRA expert Ed Slott, a certified public accountant and founder of Ed Slott & Company. "You should always invest through a Roth IRA," he says. "To start building your retirement account from dollar one tax-free is the Holy Grail."
For a refresher on Roth IRAs, and why experts say you should invest in them early and often, read on.
There are two kinds of IRAs — short for individual retirement accounts — which investors can use to save for retirement in a tax-advantaged way.
A traditional IRA gives you a tax benefit up front. You contribute to the account with pre-tax dollars, thereby lowering your taxable income for the year in which you make the contributions. But you'll owe the IRS when you withdraw from the account in retirement, with such distributions taxed as income.
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Investors fund a Roth account with money they've already paid tax on. "So the trade-off is, you don't get a tax deduction," Slott says. "Big deal! Most young people haven't reached their earnings peak, and tax deductions aren't worth much when taxes are low."
In other words, the trade-off is well worth what you get in return, says Slott. That's because your contributions to a Roth grow tax-free in your account, and once you withdraw them in retirement, you won't owe Uncle Sam a nickel. "Why would you build an account that you'll owe some portion of it back to the government, when you can build one for you?" he says.
Both kinds of accounts come with some strings attached. For each, you must have earned income to contribute and you can't contribute more than you earned. You can contribute no more than $6,000 for 2021 ($7,000 if you're age 50 or older) for either type of account.
The maximum you can contribute to a Roth begins to phase out for single filers making more than $125,000 and married joint filers making more than $198,000. And if you're looking to claim the tax break from a traditional Roth, there are limits to the deductibility of your contribution depending on your income and whether you or a spouse are covered by a retirement plan at work.
When it comes to starting to invest in a Roth, "generally, sooner is better," says Amy Richardson, a certified financial planner with Schwab Intelligent Portfolios Premium. "The sooner you invest, the longer your money is growing and compounding tax-free."
And over the long run, the effects of a Roth's tax advantage can make a big difference in the staying power of your portfolio.
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Consider a 23-year old making $40,000 a year who contributes the maximum $6,000 per year to her traditional IRA. If she earns 8% per year on her investments, by the time she's 67, she'll have a cool $2.3 million before taxes.
If she invests in a Roth IRA instead, she'll have $2.3 million and no tax obligation, meaning she could withdraw less to cover her expenses and stretch her money further.
Either way, she stands to earn much more in an IRA than she would have earning the same rate in a taxable account: less than $1.4 million.
Intrepid investors needn't wait until their first grown-up job to get started, either. Minors with earned income can contribute up to the amount they earned to a Roth, or their parents can on their behalf. "They have to have legit employment," Slott points out. "You can't pay them for cleaning up their room."
But if your kid has a job, funding their IRA can help teach the importance of diligently saving for retirement as well as the joy of exploiting a delightful little tax loophole. "When she was a kid, my daughter worked at the library and made $350, so I put $350 in a Roth for her," says Slott. "She said, 'This is great! I made it and spent it and then you put it back.' Now she's in her 30s and contributing the max to her Roth."