Essentially, you can choose between a “traditional” IRA and a Roth IRA. (Other types of IRAs are available if you’re self-employed.)
With a traditional IRA, you contribute “pretax” dollars, so your contributions are generally tax-deductible, depending on your income limits and whether you also have a 401(k) or other retirement plan at work. In 2016, you can contribute up to $5,500 to your traditional IRA, although the limit rises once you reach 50. You can fund your IRA with many types of investments – for example, stocks, bonds, and government securities– and your earnings grow on a tax-deferred basis.
A Roth IRA has the same $5,500 annual contribution limit and can also be funded with many types of investments. But there are some key differences. You can only contribute to a Roth IRA if your income is below a certain threshold, but that threshold is quite high, especially for younger workers starting their careers. So you’ll likely be eligible. However, your contributions are never tax-deductible, so you’re basically funding your Roth IRA with money on which you’ve already been taxed. But your earnings can grow tax free, as long as you don’t start taking withdrawals until you’re 59? and you’ve had your account at least five years.
Assuming you can contribute to either a traditional or a Roth IRA, which should you choose? There’s no one right answer for everyone, but as a younger worker, you may be able to gain two important benefits from contributing to a Roth.
First, since you’re probably earning much less now than you will later in your career, you’re likely in a relatively low tax bracket. So it may make sense to pay income taxes now on your Roth contributions, rather than pay the taxes later on withdrawals from a traditional IRA. And second, a Roth IRA may provide more flexibility than a traditional IRA. Usually, the only way to get money from a traditional IRA before you retire is through a short-term loan; otherwise, you can get hit with both taxes and penalties on early withdrawals. But with a Roth IRA, you can withdraw your contributions (not the earnings) penalty free to help pay for your first house or to go back to school.
Still, as mentioned above, there’s no hard-and-fast rule as to which IRA is better for younger workers. For example, if you are certain you’ll be in a lower tax bracket when you retire, you might be better off by taking the yearly tax deductions from your traditional IRA and then paying taxes on the withdrawals when you retire. But that’s a hard prediction for anyone to make.
Your tax advisor may be able to provide some guidance on whether a traditional or a Roth IRA is better for you – but either one can be a valuable resource for that day, many years from now, when you say “goodbye” to work and start a new phase of your life.
Edward Jones, its employees and financial advisors cannot provide tax or legal advice. You should consult your attorney or qualified tax advisor regarding your situation.