Hands-down, the Roth IRA is an excellent retirement savings vehicle for younger people. Since their introduction in 1998, Roth IRAs have been garnering respect (and dollars) from knowledgeable investors for the advantages they have over traditional IRAs.
Why Open an IRA in the First Place?
Why do I continue to preach the benefits of IRAs as great starter investments for young adults? Simple: taxes and the power of compounding.
Here’s an example: Let’s say you make a $100 investment in a fund that rises 20% in a year. After that year, you’d have $120. Instead of selling your shares, you let them ride, and the fund gains another 20% the next year, bringing your investment value up to $144. That’s an additional $4 in gains over the first year (or 4% on the original $100 investment) generated because you gained 20% not only on your original investment, but also 20% on all the gains earned in the first year.
While this might not seem like an impressive amount, that earnings potential grows even higher with each passing year, so long as the investment prospers. If you start actively investing a set amount each year, adding to the amount generated by what the investment earns on its own, you create even larger potential earnings.
Taxes and IRAs
If you’re just starting out in your career, you’re likely in one of the lowest tax brackets, making it a fantastic deal to pay taxes on retirement savings now as opposed to when you’re older and in a higher bracket. And in this economy, many first-time jobs don’t come with 401k retirement plans attached, so there’s no other available vehicle for forced retirement saving.
Plus, for most, an IRA gives you more flexibility over where and how to invest. 401ks often have few, and sub-par, investment choices.
While a traditional IRA (short for “individual retirement arrangement”) allows you to deduct your contributions pretax, it also locks your money in until you are 59 1/2 years old (unless you feel like paying a 10% fee on withdrawals, plus federal taxes), and forces you to take distributions upon reaching the age of 70 1/2, paying federal taxes at your future — and possibly higher — tax rate.
In contrast, when contributing to a Roth IRA, you invest with after-tax dollars now and can withdraw funds tax-free after the age of 59 1/2 or if you meet other IRS qualifications (for instance, if the distributions will be used for a first-time home purchase, or to help with a disability). Once you do hit retirement, there is no requirement on distributions — if you don’t feel like taking money out or don’t need it, you can leave it in there to continue growing.
I’ve calculated the taxes one would pay on an investment in Vanguard S&P 500 Index Fund (VFINX) in the 28% bracket (the highest bracket one could nominally fall into to be under the income limit to be eligible to invest in a Roth IRA) in both types of IRAs.
As long as you are making steady contributions and you’ll be in the same or a higher tax bracket in retirement, a Roth IRA will net you more savings for retirement and far fewer tax headaches than a traditional IRA along the way — all other things, such as your tax bracket in retirement, being equal.
Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.