If you are a millennial, you may not be aware of the various retirement accounts you can use to build up your savings big time- starting now.
Two of these accounts are the traditional IRA and the Roth IRA, but which is the best option for millennials’ savings?
Let’s dive in!
The Roth IRA vs. the Traditional IRA
Good financial advice would say to use your 401k as your primary retirement savings vehicle. This advice focuses on your tax level being higher today because you’re in your peak working years, and then in retirement, you don’t need as much income. With your income being lower in retirement, you’ll be taxed at a lower rate. We are going to discuss why that is wrong.
For anyone that is young in age should consider a Roth IRA or a Roth 401k. Let's go through the differences in both.
Roth IRA or a Roth 401k
A 401k allows you to contribute $19,500 right now, and that’s associated directly with your employer. Both types of accounts are meant not to be used or be accessible until retirement. The government gives you an incentive to save for retirement, and they give you tax incentives along the way to incentivize those savings.
*Millennials and young adults should consider a Roth IRA or a Roth 401k.
An IRA is an individual retirement account, not associated with an employer that anyone can open, and you don’t have to have it through your job. Through an IRA, you can contribute up to $6,000 per year. How a traditional IRA account works is you get a tax deduction today, meaning if you have a $100,000 salary, you contribute $20,000 to your retirement account.
For tax purposes, the IRS only looks at it as if you have $80,000 of taxable income. The IRA is a way to save $5 000 – $10,000 in terms of taxes today. Once you contribute all that money to a traditional 401k or IRA, it grows tax-deferred, meaning you don’t pay until retirement when you take that money out and owe taxes on it at that point.
The other downside with the traditional IRA is that at some point, the government will decide that they’ve given you enough tax incentives and say that you are required to now take money out of this account. Usually, the government provides the variable for how much to take out each year. This variable starts around 72, with the idea that your account, from their perspective, will reach zero the day you pass away.
With Roth IRA, it does the exact opposite.
With a Roth account, you put money in after you’ve already paid the taxes today. As long as you meet all the requirements, that money will grow tax-free, and you never pay taxes on it again. You get no tax deductions today, and it may make things tighter in your cash flow because you’ve already paid the taxes.
Okay, stick with me.
Consider the following example where we compare the Roth and the traditional IRA. Let’s say you had $10,000 go into the Roth, but $4000 went to taxes.
For the traditional IRA, let’s say you had the $6000 go in, with what we assumed is the tax savings you got from the traditional IRA, and you reinvested that too. In a way, you get a double whammy with a traditional. In our calculation, we factored in age 30 in the retirement age of 68 and assumed a 9% calculation to play around with tax rates. All in all, if you grow your money, and you invested the difference in taxes, as well as used a traditional 401k, or traditional IRA, the Roth would still come out ahead.
If you didn’t reinvest Roth’s taxable account, you would have about 3 million dollars more in Roth.
So even though you’re paying more in taxes today, and it’s all more painful today, throughout a career with the way compounding interest works, you’ll save hundreds of 1000s, if not millions of dollars on taxes alone, just by using a Roth IRA or Roth 401k instead of a traditional one.
A significant factor is that even if you have used a traditional IRA, the government will force you to start taking out money at some point. If your first-year RMD is required, the minimum distribution will be a million dollars; you’re going to have a high tax bracket with a million dollars. So even if you probably had a higher tax bracket, with a million dollars than you might have today, because that’s what the IRS is going to require you to take out and get taxed on.
Many financial gurus out there will say using the traditional 401k or traditional IRA is the better route, but it’s not the better route when you factor in taxes.
The Roth IRA, for most millennials, is going to be the better option for building long-term wealth. Ensuring you factor in all the pieces of the variables that go into saving and taxes can help you grow your wealth in the best possible way while minimizing your tax burden.
See you next time!