Millennials are all over the Roth IRA.
According to data from T. Rowe Price, investors younger than age 34 have over eight times more cash in Roth IRAs than in its older sibling, the Traditional IRA.
Why are they choosing the Roth over its precursor? We'll explain.
The difference between a Traditional and Roth IRA
IRAs (Individual Retirement Accounts), are pretty much what they sound like: Accounts opened and maintained by an individual with the express purpose of saving money for retirement.
The two main types of IRAs are called the Traditional IRA and the Roth IRA, and the most noteworthy differences between them are:
1. The income limit. Anyone can open and contribute to a Traditional IRA, but there's an income cap on the Roth IRA: Only married people earning less than $181,000, or single people earning less than $114,000, are allowed to make the maximum yearly contribution of $5,500 ($6,500 for people age 50 or older).
2. Taxes. Contributions to a Roth IRA are taxed when they're made, so you can withdraw the contributions and earnings tax-free once you reach age 59 1/2. Traditional IRA contributions, on the other hand, are tax-deductible when they're made. Both contributions and earnings are taxed when you withdraw them starting at age 59 1/2.
Right there, you can see a clear advantage to the Roth IRA: You only pay taxes on a portion of your savings (your contributions), while with a Traditional IRA, you're taxed on every penny (contributions and earnings).
You can learn more about the specifics of each account on the IRS website.
Why Roth IRAs are well-suited to Gen Y
T. Rowe Price highlights the following advantages of Roth IRAs that particularly benefit younger generations:
1. A long growth period earns more tax-free savings.
The longer the contributions have to compound, the more earnings the contributor will be able to withdraw tax-free later. (This chart illustrates the incredible power of compound interest.) Millennials, who have a long time until retiring, are perfectly positioned to give their savings time to grow.
2. Millennials may pay less in taxes while they're young.
Younger workers may be earning less today than they will be later on, therefore keeping them in a lower tax bracket and paying less in taxes today. It's worth noting, however, that because we can't predict the future, it isn't guaranteed these workers are in a lower tax bracket today than they will be in early retirement.
3. Roth IRAs allow penalty-free early withdrawals.
While best practice is always to keep your hands off retirement savings, Roth IRAs do allow early tax and penalty-free withdrawals of your contributions (but not earnings) if you need them, while the same withdrawals from a Traditional IRA incur taxes and a 10% penalty fee.
"I love Roth IRAs!" says certified financial planner Sophia Bera of Gen Y Planning. She explains that Roth IRAs are suited for various points in a millennial's life:
"People change tax brackets throughout their lives," she says. "M illennials are changing jobs every few years, and their income can range quite a bit from one year to the next. Also, sometimes parents drop down to part-time work or take time off to raise a family. When this happens, they'll often be in a lower tax bracket, which could be a great time to contribute to a Roth IRA."
As Bera points out, we can't predict tax rates or future earnings, but we do know that withdrawing our savings tax-free tomorrow could be a major advantage — so millennial or not, a Roth IRA is an option worth considering.
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