Personal Finance

Why Younger Investors Should Absolutely Love the Roth IRA

Words "tax free" on blackboard, with calculator

Americans aren't saving much. In fact, 19% have no savings at all, according to Bankrate, while 21% save only 5% of their yearly income. That's a whopping 40% of households with nearly nonexistent savings.

Savings are particularly important for younger folks in their 20s and 30s who have plenty of time to save for retirement. It's easier said than done, though as 47% of millennials say one of their biggest fears is being unable to provide for basic needs in retirement, according to the Transamerica Center for Retirement Studies.

Words "tax free" on blackboard, with calculator


People can contribute up to $6,000 combined in IRAs each year. Investors in their 20s and early 30s should consider taking advantage of the benefits of a Roth Individual Retirement Account (IRA), over those provided by other retirement savings accounts, such as a traditional IRA and 401(k), for three reasons.

1. The money will be tax free at retirement

One of the primary distinctions between a Roth IRA and a traditional IRA is when the tax advantages are applied. A Roth IRA has no effect on your tax situation in the year you contribute it, while contributing money to a traditional IRA makes you eligible for a tax deduction in the year you contribute it.

Let's illustrate the difference: If your salary is $40,000 and you contributed $4,000 to a Roth IRA, your taxable income for the year is still $40,000 and you'll owe tax on that amount. If you contribute the same amount to a traditional IRA instead, you can deduct $4,000 from your taxable income, so you'd only pay taxes on $36,000 for that year.

If you're only just learning about IRAs, this distinction might make the Roth IRA seem like the less advantageous account, but it isn't! The differences show up in when you are taxed: Qualified withdrawals from a Roth IRA will not be taxed when you retire, while traditional IRA withdrawals will be subject to your ordinary income tax in retirement.

It's not uncommon for taxes to sound like boring arcana to young people. But the ability of a Roth IRA to grow over the decades until your retirement and then be withdrawn tax free illustrates how tax decisions can seriously impact your future.

Imagine you save $4,000 in your Roth IRA every year from the age of 26 to the age of 66. By the time you reach 66, you'd have accrued a total of $854,438 , assuming an average stock market return of 7%. When you retire, your qualified withdrawals are entirely tax free, so you actually have $854,438 to live on.

If you invest the same amount yearly in a traditional IRA, assuming the same rate of return, the accrued amount is the same. However, with a traditional IRA, you must take required minimum distributions (RMDs) starting at age 70 1/2 , after becoming eligible to take withdrawals at 59 1/2. RMDs are how the government forces you to give it a cut of your money in tax revenue, but Roth IRAs do not have RMDs. The money from your RMDs will be taxed upon withdrawal -- eating a sizable portion of it. And if you're living on a fixed income as many retirees do, the money goes straight to the IRS when you need it the most.

Plus, most people earn less in the early stages of their careers than they do later, meaning their income is taxed at a lower rate during their younger years. If you are at a 12% marginal tax bracket in your 20s and early 30s, and at a 22% marginal tax bracket when you retire, by using a Roth IRA at least some of the money you withdraw has been taxed at a much lower rate.

2. Withdrawals for your first down payment on a home can be tax and penalty free

Planning and saving for your golden years is worrisome for young people who also saving and planning for earlier life events like buying a home.

Withdrawing money from either a Roth or a traditional IRA before the age of 59 1/2 isn't usually advisable, because early withdrawals are subject to a 10% tax penalty .

But there's a sweet exception: First-time home buyers can withdraw money for a down payment from their Roth IRA, and it won't be subject to either taxes or penalties, with certain provisions. As long as you haven't owned a home in the last two years and you've had a Roth IRA for at least five years, you can withdraw your contributions (the original amount you put in) at any point without penalty, and you can also withdraw as much as $10,000 of any investment gains with no penalty and no tax -- as long as it goes toward the down payment for your first home. A traditional IRA also lets you withdraw contributions without penalty for your first home, but the withdrawals are not tax free like those from a Roth account are.

Millennials are having a harder time than past generations accumulating the down payment for their first home, partly due to income pressures from higher debt levels (credit card, student loan), but also thanks to sky-high home prices in many parts of the country. The effect of the Great Recession in 2008 may have also hurt the career and savings trajectories of working folks today. But for hopeful homeowners, using a Roth IRA can provide a big needed boost.

3. The accounts are self-directed, offering a wide array of investment choices

Investors open an IRA through a bank or brokerage, so the money is self-directed, meaning you choose how to invest your dollars. This is a huge advantage over savings vehicles like 401(k)s, which only have a limited number of funds chosen by the employer.

Your choices can be much wider and more flexible with an IRA. Investors can buy mutual funds, such as an index fund that tracks the S&P 500 , or they can choose individual stocks or exchange-traded funds (ETFs). IRA investors can also allocate some portion of their investments to fixed-income instruments like steady bonds and CDs. In fact, if you're a relatively new investor, investing in an IRA can help you teach yourself how to manage your money and advance you along your learning curve.

If you're a young person with dreams of retirement and home ownership, take a closer look at the benefits of a Roth IRA and consider all it can do for your savings.

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Rita Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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