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Since people in their 20s and 30s tend to make less than they do later in life, they’re ideally suited for a special kind of investment: Roth IRAs and Roth 401(k)s. Roth investments are unique in that contributions are taxed upfront, with the advantage that what’s left grows exponentially with compound interest over time, and you won’t have to worry about the taxes on the back end. The sooner you put money into them, the greater the tax savings—a reason Roth investments are commonly recommended for younger investors.
How Roth investments differ from a traditional IRAs and 401(k)s
The biggest difference between Roths and traditional IRA or 401(k)s is how they’re taxed. Traditional accounts defer the taxes you pay on what you’ve earned until retirement, whereas contributions to a Roth account are taxed right away (the tax rate varies based on your income tax bracket). Of course, it can be painful to see, say, 22% of a contribution disappear right away, but the benefit is that whatever’s left is yours—and can watch it grow with compound interest over time.
There are a few other rules and distinctions to consider, too. Unlike traditional 401(k)s and IRAs, Roth accounts allow you to withdraw contributions at any time, without paying a penalty or tax. They also don’t have required minimum distributions, which force you to begin withdrawing money from an account when you turn 72.
The biggest disadvantage to a Roth account is that unlike traditional investments, they aren’t tax deductible, which means you won’t get a break on your taxable income every year you make a contribution. Also, you won’t be able to make contributions at all if you make too much money in a year ($140,000 for single filers; $208,000 for married couples).
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Why younger people should consider Roth investments
The main reason these accounts make so much sense for Zoomers and Millennials is that taking that initial tax hit now is usually more than worth it, because it applies before your investment grows with compound interest—and because you’re relatively young, the additional amount you earn is likely to greatly eclipse your tax loss now. And since younger people tend to make less money, they pay a lower tax rate at the time of investment (e.g., %12 if you make less than $40,125) than they will at retirement.
As Stephen Rischall, CFP, explains to Investopedia:
In general, Roth contributions have an edge over traditional contributions for young people. Having tax-free distributions in retirement is great, especially if taxes go up in the future. Since younger investors have a longer time horizon, the impact of compounding growth benefits even more.
The idea is that you get the tax part over with early, when you aren’t taking too much of a tax hit. Later, in the peak earning years of middle age, when your tax rate is much higher and the runway to build up compound interest is much shorter, you might do the opposite and invest in a traditional IRA or 401(k), and defer taxes until retirement when your tax rate will drop again, as you won’t be working (or earning) as much. The latter option might be more appealing if you’re looking for cash relief in the form of tax deductions, which a Roth account can’t provide.
Everyone’s financial situation is different, so you might want to consider the advice of a financial advisor before you decide which investment you choose (or at least, fiddle around with calculators that compares Roth versus traditional accounts).
Either way, whatever you choose will likely be related to your marginal tax rate, including the rate you have now, and the rate you expect you’ll be paying later, when you retire. Since younger people tend to make less earlier in their careers, a Roth investment is commonly recommended.