Young adults with earned income can usually make annual contributions to tax-favored traditional IRAs or Roth IRAs.

Here’s what you need to know about both kinds of accounts if you’re a young adult or if you have offspring in that category.

That said, this article is targeted to the young adults of the world rather than their parents. Here goes.

Traditional IRA Basics

First and foremost, you can still make a traditional IRA contribution for your 2023 tax year as long as you get it done by April 15, 2024. The maximum contribution for 2023 is the lesser of: 

• $6,500 or

• your earned income for last year, which generally means income from wages or self-employment.

For your 2024 tax year, the maximum IRA contribution is the lesser of1

• $7,000 or

• your earned income for this year. You can make a contribution for your 2024 tax year anytime between now and April 15, 2025.

If you’re married, your spouse can also make a contribution of up to $6,500/$7,000 as long as you and your spouse have enough combined earned income to cover your combined contributions.

If only one spouse has earned income, that’s okay. That earned income can be used to cover both that spouse’s contribution and a contribution by the spouse without earned income.

Tax Advantage of Traditional IRAs

The tax advantage of traditional IRAs compared to Roth IRAs is that traditional IRA contributions are potentially tax-deductible.

But tax deductibility depends on your tax filing status, income, and participation (or lack thereof) in a tax-favored retirement plan such as a 401(k) plan at your job or a self-employed plan. Here are the details.

Income-Based Phaseout Rules

If you’re single and you participate in a tax-favored retirement plan at your job or via self-employment, the privilege of making a deductible traditional IRA contribution for the 2023 tax year is phased out between adjusted gross income (AGI) of $73,000 and $83,000.

For 2024, the AGI phaseout range is $77,000-$87,000.

If you’re single and you don’t participate in a tax-favored retirement plan, there is no phaseout rule for you.

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

For 2024, the phaseout range is $123,000-$143,000.2

The Tax Bracket Factor

The deductibility advantage for traditional IRAs is smaller if you’re in a lower federal income tax bracket, such as the 10 percent or 12 percent bracket.

For 2023, the marginal federal income tax rate for a single-filing individual with taxable income of more than $44,725 is 22 percent. Those with more modest income are in the 12 percent or the 10 percent bracket. 

For 2023, the marginal federal income tax rate for a married joint-filing couple with taxable income of more than $89,450 is 22 percent. For those with modest income, that rate is 12 percent or 10 percent.

For 2024, the marginal federal income tax rate for a single-filing individual with taxable income of more than $47,150 is 22 percent. For those with more modest income, the rate is 12 percent or 10 percent. 

For 2024, the marginal federal income tax rate for a married joint-filing couple with taxable income of more than $94,300 is 22 percent. For couples with modest income, the rate is 12 percent or 10 percent.3

Tax Disadvantages of Traditional IRAs

The most important tax disadvantage of traditional IRAs compared to Roth IRAs is that your withdrawals are taxable to the extent they consist of deductible contributions and account earnings.

Another tax disadvantage of traditional IRAs is that if you take withdrawals before age 59 1/2, you will be hit with a 10 percent early withdrawal penalty tax unless an exception applies. Thankfully, one exception is for withdrawals to the extent of your qualified higher-education expenses.4

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 hits, after reaching age 73. Of course, you may think this disadvantage is so far in the future that it’s not a concern for you right now. Understood!

Roth IRA Basics 

You can still make a Roth IRA contribution for your 2023 tax year as long as you get it done by April 15, 2024. The maximum contribution for 2023 is the lesser of

• $6,500 or

• your earned income for last year.

For your 2024 tax year, the maximum Roth IRA contribution is the lesser of5

• $7,000 or

• your earned income for this year.

You can make a contribution for your 2024 tax year anytime between now and April 15, 2025.

If you’re married, your spouse can also make a contribution of up to $6,500/$7,000 as long as you and your spouse have enough combined earned income to cover your combined contributions.

If only one spouse has earned income, that’s okay. That earned income can be used to cover both that spouse’s contribution and a contribution by the spouse without earned income.

Tax Advantages of Roth IRAs

The biggest tax advantage of Roth IRAs compared to traditional IRAs is that qualified distributions from a Roth IRA are federal-income-tax-free and usually state-income-tax-free too. Qualified distributions can be taken after you, as the account owner,

• have reached age 59 1/2 and

• have had at least one Roth IRA open for more than five years.

While age 59 1/2 seems far in the future, the idea of being able to take tax-free distributions after that age should be appealing to you. The idea is even more appealing if you expect to be in a higher tax bracket during retirement. Given the current state of this country’s fiscal affairs, that’s not an unreasonable expectation.

 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 your Roth IRA balance untouched so you can continue to accumulate earnings that can eventually be withdrawn tax-free. But it’s good to know that you can take some Roth withdrawals if you really need to, with no tax hit.

 A third Roth IRA tax advantage is that Roth accounts are exempt from the RMD rules for as long as you live. So, if you don’t need your Roth IRA money during retirement, you can leave your (hopefully big) balance untouched. Then you can leave the account to your heirs, who will usually be able to take tax-free qualified Roth withdrawals after you’re gone. Once again, this advantage may not seem very important right now, but you won’t remain young forever.

 Finally, unlike with traditional IRAs, the privilege of making annual Roth IRA contributions is unaffected if you participate in a tax-favored company or self-employed retirement plan.

Tax Disadvantages of Roth IRAs

 Know this: Roth IRA contributions are not tax-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.

 Next, there are income restrictions on your right to make annual Roth IRA contributions. For the 2023 tax year, the Roth contribution privilege for an unmarried individual is phased out between AGI of $138,000 and $153,000. For a married joint-filer, the Roth IRA contribution privilege is phased out between AGI of $218,000 and $228,000.

 For the 2024 tax year, the Roth contribution privilege for an unmarried individual is phased out between AGI of $146,000 and $161,000. For a married joint-filer, the Roth IRA contribution privilege is phased out between AGI of $230,000 and $240,000.6

 Key point. For most young adults, the income restrictions will not be a problem.

Income Too High

If your income is too high to make deductible traditional IRA contributions and also too high to make Roth IRA contributions, you can always make non-deductible traditional IRA contributions. High income does not preclude this option.

What Can Modest Annual IRA Contributions Amount To?

Okay, this is all very interesting so far, but how about some quantification?

By making relatively modest annual IRA contributions starting at a young age, you can potentially accumulate quite a bit of money by retirement age. 

• If, starting at age 22, you contribute $2,500 to a Roth IRA at the end of each year for 38 years, the Roth account would be worth about $269,000 at age 60, assuming a 5 percent annual rate of return. If you assume a more optimistic 8 percent annual rate of return, the account would be worth about $551,000 at age 60. Over the years, your total contributions are only $95,000 ($2,500 x 38).

• If you make bigger annual contributions as you get older, you could wind up with a ton in your Roth account by age 60. Here’s the proof: Starting at age 22, you contribute $2,500 to a Roth IRA at the end of each year for 10 years. Then you contribute $5,000 a year for the next 28 years. Assuming a 5 percent annual rate of return, your account would be worth about $415,000 at age 60. If you assume an 8 percent annual rate of return, the account would be worth about $789,000. Your total contributions are only $165,000 [($2,500 x 10) + (5,000 x 28)).

• If you make the same contributions to a traditional IRA, you will wind up with the same balances, but most or all of your withdrawals would be taxable. If all your contributions are to a Roth IRA, however, withdrawals taken after age 59 1/2 would be federal-income-tax-free. Plus, you would benefit from the other Roth IRA tax advantages explained earlier. Of course, this assumes that the current federal income tax rules for Roth IRAs will remain unchanged. Fingers crossed!

Takeaways

If you need current tax savings, making deductible traditional IRA contributions may be the best option. Just make sure your contributions will, in fact, be deductible. 

If you don’t need current tax savings from your contributions and you expect to be in a higher tax bracket during retirement, making Roth IRA contributions may be the best option. As a general rule, the more affluent you expect to be, the better the Roth IRA option looks.

If your income is too high to make deductible traditional IRA contributions and also too high to make Roth IRA contributions, you can always make non-deductible traditional IRA contributions. High income does not preclude this option.

If you already have money in one or more traditional IRAs, consider converting your balance(s) into Roth IRA status. (There is an income tax cost to converting.)

Assuming you don’t run afoul of the income-based limits, you can make traditional or Roth IRA contributions on top of contributions to a company or self-employed retirement plan. The more money you can get into tax-favored retirement accounts, the better. And the sooner the better.

Remember. You have until April 15, 2024, to make a traditional or Roth IRA contribution for your 2023 tax year.

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Matt Bontrager