4 Reasons Roths Are Right for Younger Investors

One of my young relatives started his first real job a few years ago. He has been getting his sea legs financially, and periodically reaches out to me with quick questions about what to do—about withholding amounts, paying off student loans, and what type of credit card to get.

The other day he texted me with a query that was short and to the point: "I just got a tax refund and would like to save the money. Where should I put it?"

Knowing that I had to act fast to harness his enthusiasm for saving, I kept my response similarly (and if I'm honest, uncharacteristically) brief: "A Roth IRA," I replied back. We had a quick exchange about investment providers and investment choices. "Done. Thanks!" were his last words to me.

Of course, there are few if any "one size fits all" pieces of financial planning guidance, except for "save early and often." In hindsight, I probably should have hedged and asked a few more questions. In my relative's case, 401(k) and traditional IRA contributions—and even simply parking the money in a taxable account—might be reasonable options. Steering his windfall into a company retirement plan could mean that he could take advantage of matching contributions; there's also a lot to be said for automatic contributions to a 401(k) plan. Choosing a traditional IRA—rather than a Roth—could net him a deduction on next year's tax return. (He had already filed for 2017.) A taxable account would give him the most flexibility to pull money before retirement.

But if you have young people in your life who ask you about where to stash additional cash they've managed to save from their jobs—and you know they don't have time to play "20 Questions" with you—steering them to a Roth IRA is almost never too far wrong. Here are four reasons why.

Reason 1: Roth IRAs offer a lot of flexibility on withdrawals. Young folks are often multitasking with whatever savings they have. Ideally, they’d let the cash build up until retirement, the better to enjoy a long runway for tax-advantaged compounding. In reality, however, many of them are saving for shorter-term goals as well: home and car down payments and weddings, for example. From the standpoint of allowing for withdrawals before retirement, the Roth IRA is miles ahead of other tax-sheltered vehicles. That’s because Roth contributions can be withdrawn at any time and for any reason with no taxes or penalties. By contrast, early withdrawals from company retirement plans and traditional IRAs carry taxes, penalties, or both. Withdrawals from the investment earnings component of a Roth IRA before age 59½ may trigger penalties and/or taxes. Given that the bulk of young investors’ IRA assets will consist of contributions, Roth IRAs offer a huge escape hatch with the opportunity for tax- and penalty-free withdrawals.

Reason 2: As long as you have earned income, IRAs are open for contributions regardless of employment status. Yet another big positive with IRAs generally—either Roth or traditional—is that you can contribute to them and hang on to them regardless of your job situation—as long as you have earned income from somewhere. That's a particularly big plus given that roughly a third of the workforce is currently estimated to be employed in the "gig economy" and not on the payroll of a single employer; that number is expected to rise to 43% of all workers by 2020. As long as you have earned income, you can contribute to an IRA; because you're contributing to the IRA outside of your workplace, you won't have to worry about rolling the money out of the account when you leave your job—in contrast with a company retirement plan.

Of course, ideally young folks would contribute to both an IRA AND a company retirement plan, whether a 401(k) or a retirement plan for self-employed folks, like a SEP-IRA or Roth 401(k). Company retirement plans often offer matching contributions, something you won't get with an IRA. But realistically, some young people just starting out don't have the wherewithal to contribute to both. From the standpoint of portability and flexibility, the advantage goes to the IRA, especially for young people who haven't signed on with a single employer.

Reason 3: The tax trajectory for young people is often up. A contribution to a traditional IRA may be deductible on a young person’s tax return, provided they fall below the income thresholds outlined here. So isn’t that bird in the hand—the tax break today on the deductible traditional IRA contribution—worth more than the tax break on withdrawals that comes along with Roth accounts? Possibly, if the investor’s tax rate goes down in the future. But if the investor’s tax rate goes up, as is often the case with young folks whose careers and earnings trajectories are in the early stages, it’s better to pay taxes today, at lower rates, and push the tax break into the future. In this video, financial planning guru Michael Kitces discusses why investors should focus on their own personal tax situations and likely income trajectory when making the Roth versus traditional decision, rather than trying to guess where taxes are headed.

Reason 4: Maximum flexibility over investment choices. Yet another reason a Roth IRA is so easy to recommend is that all IRAs, whether Roth or traditional, give the investor a huge degree of latitude over what investments to put inside of it. Of course, that can invite trouble, as evidenced by the spate of news stories about investing in bitcoin inside of an IRA. But that “open architecture” also enables retirement savers to align their portfolios with their investment philosophies. True believers in the merits of low-cost, no-nonsense investing can populate their portfolios with index funds or ETFs, while hands-off types can use a target-date fund, for example.