Roth or Traditional for Young Investor

[mountainsoft]

I convinced my daughter to start an IRA a couple years ago. I helped her set up a traditional IRA since that was the account type we had at the time. She only earns around 21K per year so she isn't able to contribute much, and only has about 7K in her IRA with no other retirement savings. Every little bit helps I suppose.

Anyway, I'm working on converting our tIRA to a Roth, and it got me thinking whether a Roth would be a smarter choice for her as well. If so, why?

 

[JDARNELL]

Roth. Tax free growth.

 

[Red Badger]

Roth. Tax free growth.

There is an argument for traditional as the compounding of those extra $$ helps with juicing the miracle of compounding and time. But I'm not wanting to start a dust up.

I think it comes down to chocolate or vanilla. Just get the ice cream!

BTW. Doing same with DS, nephew and niece. Getting them to save, index invest, avoid (unwarranted) debt, LBYM. Rather agnostic as per Roth or traditional. Kinda like the pay off mortgage argument (3.375% for us, so I didn't).

 

[atmsmshr]

Roth is a great way to go while in a low tax bracket. At 21k / year, there is no advantage to using a 401k.

 

[Onward]

Roth

 

[davebarnes]

TI think it comes down to chocolate or vanilla. Just get the ice cream!

Exactly.

 

[LOL!]

It is not so cut and dried.

If she pays income taxes, then a Roth might not be a good idea.

For instance, if some contribution to a traditional IRA will be deductible and reduce her income taxes AND if later when she withdraws it, her income is so low or deductibles so high that she is not taxed on the withdrawals, the traditional is a better option.

So my point is that just because someone is low income does not mean Roth is better.

Consider that over 40% of US families do not pay any federal income taxes, so clearly Roth IRAs are good for those folks if they can and are allowed to contribute. But the next tier up where a family has to pay income taxes means that a tIRA could reduce their income taxes to zero and these folks aren't going to have big withdrawals in retirement, so may have zero taxes in retirement, too.

 

[steelyman]

Another vote for the Roth.

 

[FlaGator]

Roth, and put some in for her if you can.

She's unlikely to be paying much income tax, if any, so the value of the Trad IRA deduction is minimal

If she has a 401(k) or similar with a match, she should contribute enough to get the maximum match, even if it hurts - "free" money

 

[OldShooter]

Roth ... She's unlikely to be paying much income tax, if any, so the value of the Trad IRA deduction is minimal

If she has a 401(k) or similar with a match, she should contribute enough to get the maximum match, even if it hurts - "free" money

+1

But realistically, the choice is a crap shoot. One can play with numbers but tax policy and rates will change many times before her retirement and what the rules and rates will end up being is unknowable.

For example, RMDs were invented long after I started contributing to a 401K. Who is to say that Roth distributions over a certain amount won't be taxed just like social security is taxed and Medicare charges are means tested now? It's not at all impossible that at some point they'll begin taxing based on assets in addition to taxing income. The government offers no guarantees of predictability or fairness.

 

[Animorph]

I like Roth's for most people just starting out.

Even if they are paying taxes, it is likely at a lower rate than they would have to pay taking the money out of a tIRA in the future.

In an emergency you can withdraw your contributions without penalties. So you can stretch a little bit to contribute to the Roth. If you stretched a little too far, take some back out.

 

[pjigar]

I wish someone told me importance of Roth when my income was low and I was on lower tax bracket. I would recommend Roth until she moves in 20%+ bracket.

 

[Brat]

I recommend a Roth as well. Once it has been in place 5 years she can withdraw $ for things like buying a home.

 

[clifp]

Single and make under $157,000 Roth
More than that I'd go traditional.

 

[Bryan Barnfellow]

A bit off topic; but, I have an acquaintance who owns a small business. For his company advertising he sometimes uses his children in the ads and pays them the going rate for child actors/models. Then he puts the funds into IRAs that he set up for them.

-BB

 

[DEC-1982]

Roth, lifetime tax free growth.

 

[RunningBum]

Roth. I ran a very quick taxcaster on a single person with 21K of income and came up with $303 in taxes. There's very little you can save by doing a traditional IRA. Unless it looks very likely she'll always have very low income and perhaps pay no taxes in retirement, the Roth is the way to go.

The other advantage is that she could pull from the Roth without penalty to pay for a house, and should have a couple other ways to pull from it before 59.5 if needed, that aren't possible with a tIRA.

 

[Independent]

Roth. Tax free growth.

I'm sure this has been posted many times before, but here we go again.

For equal tax rates, the simple comparison between Roth and traditional is a wash.

Suppose I am willing to forego $6,000 of spending this year so I can save for retirement and I'm in a 25% tax bracket.

I can contribute $8,000 to a tIRA. That only costs me $6,000 of spending money due to the taxes I avoid. Now, suppose my money doubles before I withdraw it. I'll have $16,000 before tax and $12,000 after tax.

Or, I can contribute $6,000 to a Roth IRA. Suppose my money doubles before I withdraw it. I can withdraw $12,000, with no tax.

In both cases, giving up $6,000 in spending today gives me $12,000 in spending later.

"The Roth is better because you don't pay taxes on the investment income" is too simple. The traditional does just as well because I have investment earnings on the money I didn't pay in taxes, and I get to keep some of that money.

This assumes that all the contributions and withdrawals are subject to the same tax rate. Actual decisions involve thinking about how my taxes would look in the future if the gov't doesn't change tax policy, then thinking about how policy might change. It also involves other details about the differences between the Roth and traditional that people have mentioned above.

 

[kaneohe]

I recommend a Roth as well. Once it has been in place 5 years she can withdraw $ for things like buying a home.

A common misconception...........while true, you do not have to wait 5 yrs to withdraw original contributions which can be withdrawn tax/penalty free anytime. Earnings, however, cannot be withdrawn tax/penalty free until your first Roth is 5 yrs old AND you are 59.5 y.o. There are a limited number of exceptions to these rules.

 

[kaneohe]

If income is 21K (numbers are sensitive to this input so re-evaluate if income is slightly different), put 1.8K in TIRA and rest in Roth. This combo reduces AGI to get factor for savers credit to max 0.5 and reduces tax to 0. Since there is no more tax to be saved, further TIRA gains nothing so best to put rest in Roth.
https://www.irs.gov/retirement-plan...etirement-savings-contributions-savers-credit

 

[mountainsoft]

If income is 21K (numbers are sensitive to this input so re-evaluate if income is slightly different), put 1.8K in TIRA and rest in Roth. This combo reduces AGI to get factor for savers credit to max 0.5 and reduces tax to 0. Since there is no more tax to be saved, further TIRA gains nothing so best to put rest in Roth.

Ahh, I think that's the best solution yet. I ran a 2018 tax estimate with OLT using similar numbers. For the sake of simple even monthly numbers, it looks like contributing 2040 to her traditional and 3360 to a roth would still equal zero tax (keeping her current 5400 annual contribution). Great idea, I hadn't thought of that option.

I'll have to discuss it with my daughter. Thanks.

 

[RunningBum]

Ahh, I think that's the best solution yet. I ran a 2018 tax estimate with OLT using similar numbers. For the sake of simple even monthly numbers, it looks like contributing 2040 to her traditional and 3360 to a roth would still equal zero tax (keeping her current 5400 annual contribution). Great idea, I hadn't thought of that option.

I'll have to discuss it with my daughter. Thanks.

Just wondering how $170 a month ($2040/yr) is more simple or even than $150 a month (1800/yr)? And that's $240 you're needlessly putting in a 401K, deferring a 0% tax.

 

[mountainsoft]

Just wondering how $170 a month ($2040/yr) is more simple or even than $150 a month (1800/yr)? And that's $240 you're needlessly putting in a 401K, deferring a 0% tax.

When I run the tests in the OLT tax estimator https://www.olt.com/main/home/taxestimator.asp 2000/yr seemed to be the break even point. That's 166.67 per month, I just rounded up to 170/mo or 2040 per year.

I tried 160/mo in traditional and it showed she would owe $308 tax.

Different estimators may give slightly different results. The main point was to keep her taxes low and still be able to contribute to a roth. Kaneohe's suggestion to split the contributions was one I had not considered.

 

[KCGeezer]

DS does this as well. Contributes enough to 401 to max employer contribution then remainder of his savings goal to Roth. Not sure if he factored in tax implications or not but sure makes sense.

 

[kaneohe]

When I run the tests in the OLT tax estimator https://www.olt.com/main/home/taxestimator.asp 2000/yr seemed to be the break even point. That's 166.67 per month, I just rounded up to 170/mo or 2040 per year.

I tried 160/mo in traditional and it showed she would owe $308 tax.

Different estimators may give slightly different results. The main point was to keep her taxes low and still be able to contribute to a roth. Kaneohe's suggestion to split the contributions was one I had not considered.

Good catch there! I mistakenly used the 2019 table of factors for the savers credit. The income limits there are a little higher allowing for less TIRA contribution to maintain the high factor. For 2018, you would have to increase the TIRA contribution to keep the AGI lower.