Retirement Planning for Young Adults: Never Too Early to Start
Individuals approaching retirement are likely to have young adult children. These days, social media influencers discuss IRAs and other financial instruments online, making conversations about retirement more common in younger demographics. Below, we briefly highlight the impact of investing early in life - and cover the basics of traditional and Roth IRAs detailing advantages and disadvantages of each.
How Investing Today Can Grow Tomorrow
Let’s demonstrate how a relatively modest contribution can accumulate by retirement.
For example, a 22-year-old contributes $2,000 to an IRA at the end of each year for 38 years. Assuming a 5% annual rate of return, the IRA account would be worth about $215,000 at age 60. If you assume an 8% annual rate of return, the account would be worth about $441,000 at age 60. Important to note: The money contributed was only $76,000 ($2,000 × 38).
Now, consider that same 22-year-old increases the contribution amount when they turn 32. For example, they contribute $2,000 per year for 10 years, starting at age 22, and then contribute $5,000 a year for the next 28 years. Assuming a 5% annual rate of return, their account would be worth about $390,000 at age 60. If you assume a more optimistic 8% annual rate of return, the account would be worth about $727,000. Their total contributions were only $160,000 [($2,000 × 10) + (5,000 × 28)].
$2,000 a year is a relatively moderate contribution to an IRA. It is common for individuals to contribute more than that. This is why starting an IRA as a young adult can be so beneficial.
Traditional IRA versus Roth IRA
Contributions to a traditional IRA are potentially deductible, which could reduce the tax liability for the year contributed. However, when distributions are taken, the distributions, including earnings, must be taxed.
Contributions to a Roth IRA are made with after-tax dollars in the year of contribution. However, distributions, including earnings, are tax-free for the year of withdrawal.
IRAs are subject to annual contribution limits. Regardless of whether you make traditional or Roth IRA contributions, your contributions are limited to $6,500 ($7,000 for 2024) in aggregate, if you file as single. If you are married and file a joint return, you and your spouse can each contribute up to the limit. Contributions are further limited to your earned income. If only one spouse has earned income, that income may also be used by the spouse without earned income. Earned income generally meaning income from wages or self-employment.
Traditional IRA: What are the advantages?
The most appealing benefit of a traditional IRA is the immediate tax benefit for the current year. Individuals taking advantage of traditional IRA contributions can deduct those contributions and lower their taxable income for the year the contributions are made.
However, as with any advantage, there are limits. If you file as single and participate in a retirement plan, such as a 401(k) through an employer, the deductibility of your contributions starts to decrease when your Adjusted Gross Income (AGI) reaches $73,000 ($77,000 for 2024). If you file single and do not participate in a retirement plan, this phase out does not apply to you. If you are married, file a joint return and both individuals participate in a retirement plan, the deductibility of your contributions start to decrease at $116,000 ($123,000 for 2024).
Traditional IRA: What are the disadvantages?
The main disadvantage of a traditional IRA is that distributions from a traditional IRA, including the earnings, are includible as income and ultimately taxed.
Individuals with money in a traditional IRA are also penalized if they withdraw before a certain age. A 10% penalty is applied to any withdraw taken from a traditional IRA before the individual reaches the age of 59 ½. There are exceptions to get this penalty waived. The exception for using the money to pay for qualified higher-education expenses and first-time home purchase exception would be most relatable to young adults.
Another disadvantage related to a traditional IRA is the required minimum distribution (RMD) rules. Once an individual reaches a certain age (73 in 2024), they are required to make a withdrawal and pay income tax on that withdrawal. This is probably a disadvantage a young adult should not worry about when deciding to contribute to a traditional or Roth IRA during their early years. It is, however, something to keep in mind as IRA contributions start to add up and retirement draws closer. If, for some reason you do not need the money in your traditional IRA during retirement, you will be forced to withdraw it and pay tax on that withdrawal, regardless.
Roth IRA: What are the advantages?
The biggest benefit provided by Roth IRAs is that qualified distributions, including earnings, are federal-income-tax-free. They are also often state-income-tax-free. Considering the potential accumulation of earnings when you start investing early (as noted above), this tax savings can be significant.
With any advantage there are limits. and to get those tax-free distributions, you much first reach the age of 59 ½. If you think your income will be higher when you are 59 than it is right now and you don’t anticipate the tax brackets shifting dramatically, this is an appealing option.
Another advantage a Roth IRA has over a traditional IRA is the lack of penalty or income tax assessed, if you withdraw less than the cumulative amount of your contributions. This is an important benefit for young adults who do not know what the future holds. Of course, the goal of starting an IRA is to allow the balance to grow and accrue interest, but it is reassuring to know that if money gets tight, you can withdraw without penalty.
Roth IRAs are exempt from the RMD rules. This means that if you end up not needing the money during retirement you can leave it to your children, and they will be able to take tax-free distributions. Again, this is probably not top priority for a young adult but should certainly be considered as they move closer to retirement age.
Roth IRA: What are the disadvantages?
Roth IRA contributions are not deductible, so if you are looking for current year tax benefits, the Traditional IRA might be the better choice.
Also, there are income restrictions on your ability to make Roth IRA contributions. If you are filling single, the Roth IRA contribution privilege starts to decrease at $138,000 ($146,000 for 2024). If you are married and file a joint return, the Roth IRA contribution privilege starts to decrease at $218,000 ($230,000 for 2024). It is reasonable to assume that these income restrictions are not likely to affect young adult contributors, however they are worth mentioning for the future.
Summary
It is important to note that you have until the due date of your annual tax return to make traditional and Roth IRA contributions for the prior tax year. This means that you could potentially lower your taxable income for a prior year at the time you are preparing the tax return for that year.
There are advantages and disadvantages to both traditional and Roth IRAs. If you want to lower your taxable income now and potentially move to a lower tax bracket, contribute more to a traditional IRA. If you do not want to worry about paying taxes on your retirement withdrawals, then contribute more to a Roth IRA. A key point is to start contributing early in life and most importantly, to consider talking to a professional about your options.
Please contact your Herbein tax consultant if you have questions regarding retirement planning and IRAs.
Article contributed by Jessica Halligan
