IRAs for Young Adults

To our Clients and Friends, 

Individuals with earned income can make annual contributions to tax-favored traditional IRAs or Roth IRAs. This letter explains how the two IRA options stack up for young adults. 

Key Point: You have until 4/15/24 to make a traditional or Roth IRA contribution for 2023. However, the sooner you get money into one of these tax-favored accounts, the better. 

Traditional IRA Tax Basics 

For 2023, you can make a traditional IRA contribution of up $6,500 (or the amount of your earned income, if that amount is less). Earned income generally means income from wages or self-employment. For the 2024 tax year, the maximum IRA contribution is raised to $7,000. 

If you’re married and file a joint return, you and your spouse can each contribute up to $6,500 for 2023 ($7,000 for 2024) if together you have enough combined earned income to cover your combined contributions. If only one spouse has earned income, that income can be used to cover that spouse’s contribution and a contribution by the spouse without earned income.

Traditional IRA Tax Advantage. The tax advantage of traditional IRAs compared to Roth IRAs is that traditional IRA contributions are potentially deductible. However, deductibility depends on your tax filing status, income, and participation (or lack thereof) in a tax-favored retirement plan like a 401(k) plan at your job or a self-employed plan. 

For instance, if you’re single and participate in a tax-favored retirement plan, the privilege of making a deductible traditional IRA contribution for 2023 is phased out when your Adjusted Gross Income (AGI) is between $73,000 and $83,000. For 2024, the phase-out range is $77,000–$87,000 for single individuals. If you’re single and don’t participate in an employer plan, there is no phase-out rule. If you’re a married joint-filer and both you and your spouse participate in tax-favored retirement plans, the privilege of making deductible traditional IRA contributions for 2023 is phased out between AGI of $116,000 and $136,000. For 2024, the phase-out range is $123,000–$143,000. Contact us for full details on the deductibility issue. 

In any case, the deductibility advantage is less valuable for individuals who are in lower tax brackets. 

Traditional IRA Tax Disadvantages. The main tax disadvantage of traditional IRAs compared to Roth IRAs is that withdrawals from the traditional IRA are taxable to the extent they consist of deductible contributions and account earnings. 

Another tax disadvantage of traditional IRAs is that withdrawals taken before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies. Exceptions that can apply to young adults include withdrawals taken to cover qualified higher-education expenses and first-time home purchases. 

A third tax disadvantage is that traditional IRAs are subject to the Required Minimum Distribution (RMD) rules that force account owners to start taking withdrawals, and pay the resulting income tax, after reaching a certain age. For 2024, that age is 73. However, for a young adult, the RMD disadvantage may be way too far in the future to worry about right now. Fair enough. 

Roth IRA Tax Basics 

For 2023, you can make a Roth IRA contribution of up to $6,500 (or the amount of your earned income, if less). For 2024, the maximum Roth contribution is raised to $7,000. 

If you are married, your spouse can also make a Roth contribution of up to $6,500 (for 2023; $7,000 for 2024) if you and your spouse have enough combined earned income to cover your combined contributions. If only one spouse has earned income, it can be used to cover that spouse’s contribution and a contribution by the spouse without earned income. 

Roth IRA Tax Advantages. The biggest Roth IRA tax advantage is that qualified distributions from a Roth IRA are federal-income-tax-free and often state-income-tax-free too. Qualified distributions can be taken after the account owner has reached age 59½ and has had at least one Roth IRA open for more than five years. While age 59½ may seem very far in the future to a young adult, the idea of being able to take tax-free distributions in retirement should be appealing to everyone. That said, the idea is much more appealing if you expect to be in a higher tax bracket during retirement. While predicting future tax rates is dicey, that’s not an unreasonable expectation if you are a young adult who believes you will be financially comfortable in your retirement years. If tax rates get raised for anybody, they will get raised for you!

A second Roth IRA tax advantage is that you can always take tax-free and penalty-free distributions up to the cumulative amount of your annual contributions. Of course, it’s best to leave your Roth IRA account balance untouched so you can continue to accumulate earnings that can eventually be withdrawn tax-free. But it’s nice to know that in a pinch you can take some Roth withdrawals with no tax hit. 

A third Roth IRA tax advantage is that Roth accounts are exempt from the RMD rules for as long as the account owner lives. So, if you don’t need your Roth IRA money during retirement, you can leave your hopefully big balance untouched. Then you can leave the account to your heirs who will usually be able to able to take tax-free qualified Roth withdrawals after you’re gone. Once again, this advantage may not seem very important to a young adult right now, but you won’t remain young forever!

Finally, unlike with traditional IRAs, the ability to make annual Roth IRA contributions is unaffected if you participate in a tax-favored company or self-employed retirement plan. 

Roth IRA Tax Disadvantages. First and foremost, you must understand that Roth contributions are not deductible. So, if you need your contributions to result in current tax savings, making deductible contributions to a traditional IRA may be the better choice. Just make sure that your contributions will be deductible. Check with us about that. 

Next, there are income restrictions on the right to make annual Roth IRA contributions. For 2023, the Roth IRA contribution privilege for an unmarried individual is phased out between AGI of $138,000 and $153,000. For a married joint-filer, the Roth IRA contribution privilege is phased out between AGI of $218,000 and $228,000. For 2024, the Roth IRA contribution privilege for an unmarried individual is phased out between AGI of $146,000,000 and $161,000. For a married joint-filer, the Roth IRA contribution privilege is phased out between AGI of $230,000 and $240,000.

For many young adults, these income restrictions will not be a problem. 

Modest IRA Contributions Can Amount to a Lot by Retirement Age

By making relatively modest IRA contributions starting at a young age, you can potentially accumulate quite a bit of money by retirement age.

Say a 22-year-old contributes $2,000 to a Roth IRA at the end of each year for 38 years. Assuming a 5% annual rate of return, the Roth account would be worth about $215,000 at age 60. If you assume a more-optimistic 8% annual rate of return, the account would be worth about $441,000 at age 60. Your total contributions were only $76,000 ($2,000 × 38).

If you make larger annual contributions as you get older, you could wind up with a very healthy account at age 60. Say you 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, your 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. Your total contributions were only $160,000 [($2,000 × 10) + (5,000 × 28)].

You get the idea. With manageable annual contributions, an IRA can be worth a rather eye-popping amount by the time you are approaching or entering retirement age. 

Conclusion

Making traditional IRA contributions may be the best choice if your contributions will be deductible and you need the resulting tax savings. 

Making Roth IRA contributions may be the best choice if you don’t need current tax savings from your contributions and you expect to be in a higher tax bracket during retirement than you are now. Generally, the more affluent you expect to be, the better the Roth IRA option looks.

Finally, let’s say that your income is too high to make deductible traditional IRA contributions and too high to make Roth IRA contributions. You can always make nondeductible traditional IRA contributions no matter how high your income. And if you already have money in one or more traditional IRAs, you can consider converting your balance(s) into Roth IRA status. However, there will be a tax cost to converting. 

Assuming you don’t run afoul of the income limits, you can make traditional or Roth IRA contributions on top of contributions to a company or self-employed retirement plan. The more money you can get into tax-favored retirement accounts, the better.  Talk to us about your IRA options and what might be the best tax-smart strategy given your current circumstances and expectations for the future. 

Very Truly Yours,

C.S. Smith & Associates, PLLC