January 18, 2024

Article - Setting up IRA for Young AdultsMore than half of 16-to-24-year-olds are employed, according to the most recent statistics from the U.S. Bureau of Labor Statistics. A job can teach your young adult child or grandchild how to be financially responsible. But why not encourage them to take it to the next level by saving for retirement?

Teens and young adults with earned income generally can make annual contributions to tax-favored traditional IRAs or Roth IRAs. Annual compounding can really add up in these types of accounts if individuals start when they’re in their teens or 20s. Here’s how these two retirement savings tools measure up.

Contribution Limits

The contribution limits are the same for traditional and Roth IRAs. For the 2023 tax year, a young person can contribution up to the lesser of:

  • $6,500, or
  • Earned income, which generally means from wages or self-employment.

If the young adult is married, his or her spouse can also contribute up to $6,500 if the couple has enough combined earned income to cover their 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.

Important: The deadline for making a traditional or Roth IRA contribution for the 2023 tax year is April 15, 2024. However, the sooner money lands in one of these tax-favored accounts, the sooner it can start accumulating tax-sheltered earnings for retirement.

Tax Advantage of Traditional IRAs

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, such as a 401(k) or self-employed plan.

For instance, if you’re single and participate in a tax-favored retirement plan, for the 2023 tax year, the privilege of making a deductible traditional IRA contribution is phased out between adjusted gross income (AGI) of $73,000 and $83,000. If you’re single and don’t participate in a tax-favored retirement plan, there’s no phase-out rule.

If you’re a married joint-filer and both you and your spouse participate in tax-favored retirement plans, for the 2023 tax year, the privilege of making deductible traditional IRA contributions is phased out between AGI of $116,000 and $136,000. Your tax advisor can give you full details on the deductibility issue.

These phase-out amounts go up for 2024.

Deductibility is less valuable for individuals who are in lower tax brackets. For 2023, a marginal federal income tax rate of 22% will apply to single people with taxable income of $44,725 or less ($89,450 for married couples who file jointly). People with modest incomes may be in the 10% or 12% tax brackets.

Downsides of Traditional IRAs

The main tax disadvantage of traditional IRAs — compared to Roth IRAs — is that withdrawals 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% penalty tax unless an exception applies.

Important: An exception that can apply to young adults is for withdrawals taken to pay qualified higher-education expenses.

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 bills, after reaching the “magic” age. For 2024, that age will be 73. However, the RMD disadvantage may be too far in the future to concern a young adult.

Tax Advantages of Roth IRAs

The biggest tax advantage of Roth IRAs is that qualified distributions are free from federal income tax and usually free from state income tax..

Qualified distributions can be taken after the account owner:

  • Is 59½, and
  • Has had at least one Roth IRA open for more than five years.

While 59½ will seem far in the future to a young adult, the idea of being able to take tax-free distributions in retirement should appeal to everyone, especially if you expect to be in a higher tax bracket during retirement. That’s not an unreasonable expectation if you’re a young adult who believes you’ll be financially comfortable in your retirement years.

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 Roth IRA accounts untouched so they continue accumulating earnings that will eventually be withdrawn tax-free. But it’s nice to know that, in a pinch, you can take some Roth withdrawals with no tax bill.

Another major upside is that Roth accounts are exempt from the RMD rules while the account owner is alive. So, if you don’t need your Roth IRA money during retirement, you can leave your account(s) untouched and then leave them to your heirs, who generally can take tax-free qualified Roth withdrawals after you’re gone. Once again, this advantage may not seem important to a young adult now, but of course, young adults don’t stay young forever.

Downsides of Roth IRAs

However, there are some disadvantages to Roth IRAs. Most notably, 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 check with your tax advisor to make sure that your contributions will indeed be deductible.

Also, beware: There are income restrictions on the right to make annual Roth IRA contributions.

For the 2023 tax year, the AGI phase-out ranges for the Roth contribution privilege are:

  • $138,000 to $153,000 for single people, and
  • $218,000 to $228,000 for married people who file jointly.

For most young adults, these income restrictions won’t be a problem.

Lessons Learned

Which IRA option makes sense for your child or grandchild? Traditional IRAs might be a better choice for people who need the tax savings from deductible contributions. However, Roth IRAs might be better for those who don’t need current tax savings from contributions and expect to be in higher tax brackets during retirement than they currently are. Generally, the more affluent someone expects to be in retirement, the better the Roth IRA option looks.

What options are available for people who make too much earned income to make deductible traditional IRA contributions or Roth IRA contributions? There are no income limits on making nondeductible traditional IRA contributions. Plus, people who already have money in one or more traditional IRAs can convert them into Roth IRAs. However, there will be a tax cost to converting.

For more information, contact your tax advisor or reach out to the GRF Tax Team. They can help chart the optimal strategy for future retirement savings and estate planning.

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