The Best IRA for a 20-Something Investor

If you’re 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: a traditional account or a Roth account. What would be right for you? In most cases, the answer will be Roth. This is why.

Roth vs. Traditional IRAs

A traditional IRA provides a tax deduction on your contributions and a tax deferral on any gains in the account until you withdraw the funds. Once you start making withdrawals, they will be taxed based on your tax bracket at the time.

On the other hand, Roth IRA contributions are not tax deductible, but your withdrawals can be tax deductible if you follow the rules.

Younger investors who are just starting out in their careers tend to be in lower tax brackets and do not benefit as much from the tax deductions for contributions to a traditional IRA as do older investors in higher brackets. Plus, the younger you are, the more time your account will need to grow and accumulate — and with a Roth, all that money could one day become tax-free.

Here’s a closer look at how each type of IRA works and why the Roth is usually a wiser choice for people in their 20s, especially if they can give up an immediate tax deduction.

Traditional IRA tax benefits

Traditional IRAs have been around since the 1970s and were once the only option people had. While tax benefits provided an attractive incentive for Americans to save for retirement, the government eventually wanted to reduce this incentive.

As a result, traditional IRAs can result in a large tax bill when account holders begin withdrawing their funds. The government has 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 later. These are known as required minimum distributions (RMDs).

Here’s a somewhat simplified example of how a traditional IRA can increase in value, while also accumulating a significant tax liability:

Let’s say you’re 23, currently earning $50,000 a year, and contribute the maximum allowed $7,000 for 2024 to a traditional IRA. Since you are in the 22% tax bracket, your tax deduction for your IRA contribution will save you approximately $1,540 in federal income tax.

Now let’s say you continue to contribute $7,000 per year to your traditional IRA until you turn 63 (40 times $7,000 = $280,000), and your traditional IRA grows to $1.8 million by then (which is possible with a return Annual rate of 8%). If all of your contributions are fully deductible, that means you saved $61,600 in taxes over the 40 years, assuming (for simplicity) that you stayed in the 22% tax bracket.

At age 63, you decide to retire and withdraw $50,000 annually from your traditional IRA to cover living expenses. If you’re still in that 22% tax bracket, you’ll owe $11,000 in federal income tax on every $50,000 withdrawal per year after that. In other words, you’ll only get $39,000.

If you’re in a higher tax bracket when you start taking withdrawals — either because you have more income or because tax rates have risen overall — you may still owe more. And remember, once you reach 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. Let’s say you contribute the same $6,500 a year for 40 years to a Roth IRA. You won’t get any tax deduction, but your Roth IRA still grows to $1.8 million — assuming the same 8% annual return. At age 63, you start withdrawing $50,000 per year.

The difference now is that there is no tax due on a Roth withdrawal because distributions from a Roth are tax-free as long as you have had the Roth account for at least five years and have reached age 59½. In this scenario, you can withdraw $50,000 (or whatever amount 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 on to your heirs upon your death. They will have to withdraw it eventually, but their withdrawals can also be tax-free.

Bottom line

Because of the unique tax advantages of a Roth IRA, eligible people over age 20 should seriously consider contributing to one. A Roth IRA can be a wiser choice in the long run than a traditional IRA, although contributions to traditional IRAs are tax deductible.