The age-old debate, should I use a Roth or traditional IRA? What if I’m a college student? For many of us, we’ve decided to invest, we get all excited, we calculate our net worth in 40 years of compounding, and then we realize there are so many different accounts for investing. Which do I choose? Is a traditional IRA better than Roth IRA? Is there even a difference, if so, what is it? I remember those exact thoughts when I first started investing.
I was eating a scrumptious meal at my grandparents’, chatting with one of my older cousins and asking him about his work life after college, when an innocent question on my part was asked. “Now that you are graduated, how’s your portfolio looking?” I got a humored response, followed by a genuine, “I don’t know much about investing, but I should probably start.”
We chatted for a little bit longer and that one infamous question reared its face. What is the difference between a Roth IRA and a traditional IRA?
This article will break down the differences between Roth IRA’s and traditional IRA’s, provide a list of benefits to both accounts, analyze when to use a Roth IRA and when to use a traditional IRA, and point you in the right direction regarding your own situation.
What are the Differences Between a Roth IRA and Traditional IRA?
While both Roth and traditional accounts are designed to invest for retirement, they vary in their features and benefits, as well as their limitations.
Roth IRA’s contribute post-tax dollars, meaning that you will have to pay taxes on your money before contributing to a Roth IRA. However, a Roth IRA is advantaged by allowing tax free growth saving you on taxes at withdrawal. Anyone, 18 years or older that has earned income within IRS regulated limits can open and invest in a Roth IRA. The IRS income limits are $153,000 if filing single and $228,000 if filing married jointly. With a contribution limit of $7,000 in 2024. Roth IRA’s also have no required minimum distributions, meaning that you can keep your money parked in their indefinitely, even to the point of death. One beneficial and unique feature of Roth IRA’s is that you can withdraw contributions from your account at any time, tax and penalty free, as well as some more specific rules that allow you to withdraw earnings tax and penalty free.
Traditional IRA’s defer taxes. That means that contributions to traditional IRA’s are placed into the account on a pre-tax basis, lowering your over all income level for the year of filing. If you earn $50,000 in income and contribute $5,000 to your traditional IRA, you would have only earned $45,000 in the eyes of the IRS. However, you would pay taxes when you withdraw your earnings in retirement, hopefully at a lower tax rate. Traditional IRA’s also have required minimum distributions. Generally, these are withdrawals (with a minimum amount) required to be taken starting at the age of 73. Anyone 18 years or older with earned income can contribute, but certain income limits affect the tax-deductible statues.
For more details on the specifics, please see Fidelity’s website here.
Which IRA is Better in College?
If the list of benefits and disadvantages of each didn’t explain what’s best for your situation, allow me to.
In very simple terms Roth IRAs should be used in low-income years because the tax burden will be more bearable, and traditional IRAs should be used when the primary focus is tax advantage. For a high-income earner, it makes to lower your tax burden and defer taxes until you are in a lower tax bracket. Someone making minimum wage may benefit more from the tax-free growth of a Roth IRA, making investments more valuable during retirement (anything that is tax free is more valuable than if it’s taxable, e.g. $100,000 tax free beats out $100,000 that’s taxable.)
However, let’s look at a college student. College students are in unique positions during this time of their life. These will most likely be the lowest income earning years of adult life, and this can provide college students with a decision to make. What retirement account should they use?
If you are fortunate enough to be thinking about retirement savings in college instead of student loans, rent payment, or food, then you there is one option that provides the best return over the long run. A Roth IRA will be your best option, but traditional IRAs are not a bad option.
In my personal experience, I have used both. They have both provided me with benefits, but ultimately, I will choose to fund my Roth IRA over my traditional IRA. Let’s take for example if you invested $5,000 at the age of 20 and let that compound at a rate of 7% for 45 years, you would end up with nearly $100,000. If that $5,000 was in a Roth IRA, you would get all $100,000 tax-free, but if that $100,000 was in a traditional IRA and you had a 20% tax rate in retirement, that $100,000 windfall would be worth a measly $80,000.
What if Taxes Increase?
Another important point when it comes to the Roth vs. Traditional debate is whether taxes are likely to increase or decrease in the future. If you are a college student that’s taxed at a fairly low tax rate, say 10% (effective rate for earning $15,000, filing single), then it doesn’t make sense to use a traditional IRA. You are saving a small amount of money on taxes, and you are far more likely to be in a higher tax bracket than 10% when you retire.
Let’s not forget how government policy changes over time as well. Who’s to say that you won’t be taxed at 50% by the time you retire. I’ll be laughing in my comfortable Floridan beach house with a solid Roth IRA nest egg, as others have to double my nest egg because of 50% tax rates.
The future is, however, unpredictable and diversifying your portfolio doesn’t come down to just your investment assets, but also your investment vehicles. Having a solid mix of retirement accounts, especially as your taxes begin to increase, is very important.
What Does it All Mean?
It ultimately becomes your choice whether you use a Roth IRA or traditional IRA. Don’t let this decision be the stalling factor in your investment journey as any IRA is always better than no IRA.
If you know that you are in a low-income season and foresee yourself earning much more after college than it makes sense for you to opt into a Roth account. Everyone’s situation is different, but as a blanket statement, it makes sense for most college students to open up a Roth IRA and take advantage of the power of compounding.
I personally have created four investment accounts over the last 5 years. Each of them has funds for different reasons. I gained back $115 in taxes the first year I opened and contributed to my traditional IRA, some of my funds go into a Roth 401k that I will eventually roll over into my Roth IRA, and I even have a taxable brokerage account, that I seldom ever contribute to but was what got me started on my investment journey.
If you’ve made it this far, I congratulate you. You are educating yourself on the things that matter for your future financial goals. Don’t let this new knowledge sit idly in the garage. Go out and take it for a drive.
If you are looking for more detail on the IRS regulations and rules regarding IRAs, you can find that here at IRS.gov. Always remember to do thorough research that evaluates your own financial goals before making investments.
It’s a bit short, but that’s all I have for you today.
Until the next article.
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