As a young adult just out of college, I often feel overwhelmed while adjusting to a newly independent way of living. It is hard enough to navigate the emotional side of this that many of us tend to overlook the financial side. With discretionary income coming our way possibly for the first time, it is rare for a young professional to be aware of all the opportunities available. It is easy to lose out on potential earnings that could drastically affect our future for the better. In this article series I am going to address some of the important options available to anyone who is just starting out in their career, beginning with the difference between contributing to a Roth IRA vs a Traditional IRA.
Contributing to a Roth IRA vs. Traditional IRA
You have probably heard the words “Roth IRA” at some point in your life but may not necessarily know what it means or how it differs from a Traditional IRA. They are essentially used for the same purpose: retirement savings. This means that you cannot touch the money you put in these accounts without penalty until you reach the age 59 ½ (some exceptions may apply). The only difference is the time at which you pay taxes.
In a Roth IRA, you are contributing after-tax dollars, so you let the account grow tax-free and don’t pay taxes on the withdrawals. For this reason, it is more beneficial to you if you contribute to a Roth when your marginal tax bracket is lower.
In a Traditional IRA you are contributing pre-tax dollars, so you let the account grow tax-deferred and pay taxes on the withdrawals. For this reason, it is more beneficial for you to contribute to an IRA when your marginal tax rate is higher.
In either case, you do not need to pay taxes during the life of the account, rendering it more desirable than your typical non-retirement account. Below is a chart to show the difference:
1. You have $1,000 of before-tax money to deposit today.
2. You invest in one fund and hold it until retirement (40 years from today).
3. Your money grows at an average of 6% each year.
4. Your capital gains tax bracket is 15% if contributing to a non-retirement account.
Interpreting the Graph
The first columns in the graph show that, when contributing $1,000 before tax to a Roth at a lower bracket today (12%), you will be able to pull about $2,500 more in retirement (35% bracket) than if you had contributed the $1,000 to a Traditional IRA. You can see that, as the gap in your current and future tax brackets lowers, the less impact your choice of retirement vehicle has on your future withdrawals.
As a young professional, you usually expect to make a higher salary as you move up in your career. You may want to take advantage of your current lower tax bracket to save you some money in taxes at retirement. This will make it beneficial for you to start saving now into a Roth IRA. However, this may not be the case for everyone so be sure to contact a financial or tax professional if you have any questions.
Beyond the decision between a Roth and a Traditional IRA, this graph shows that time is on your side when it comes to saving for the future. The sooner you start saving, the more likely you can grow your money tenfold.
Investment Advice offered through Bickling Financial Services, Inc., a registered investment advisor. Securities offered through Purshe Kaplan Sterling Investments, Member FINRA/SIPC Headquartered at 80 State Street, Albany, NY 12207. Purshe Kaplan Sterling Investments and Bickling Financial Services are not affiliated companies.