Many young adults tend to focus on the immediate year tax benefits of making contributions to an IRA. This is certainly one important factor in maximizing the potential of an individual retirement account, but it might not be the most valuable one.
Perhaps the biggest benefit from having an IRA is that all investments income and gains that are kept inside the account (that is, not taken as a distribution by the account holder) occur on a tax-deferred or tax-free basis. The upshot of this tax-advantaged growth is that young adults should be working very hard to start a self-directed IRA as early as possible in order to maximize their benefit.
Let’s take a closer look
Consider two individuals, one of whom makes their first $5,000 contribution to a self-directed IRA at age 25. The other individual makes their first $5,000 contribution at age 35. By the time each of these individuals reaches age 55, the value of their investments will be very different. Assuming an 8% annual rate of return, the first individual’s contribution will be worth a little over $50,000. The second individual’s same $5,000 contribution, made a bit later in life, will be worth less than half that – just over $23,000. Giving your contributions as long as possible to grow will be the key to a prosperous retirement, and that means starting an account and making annual contributions as early in life as possible.
Let’s now take this hypothetical scenario one step further and compare the long-term differences between a Roth self-directed IRA and a traditional self-directed IRA. Let’s again look at what happens to a contribution to each type of account after 30 years of growth. We’ll use the same assumptions (an 8% annual return and a 30% tax rate) for a $5,000 contribution.
After 30 years, that contribution to each type of account will have grown to just over $50,000. But because distributions from a traditional IRA are subject to tax, the value of that $50,000 account will actually be $35,000 once the distribution is taken and the taxes are paid. Distributions from a Roth IRA can be made tax-free during retirement, so that $50,000 is actually worth $50,000 to the account holder.
But what about the tax deduction that may have been available for the traditional self-directed IRA in the year of contribution, you might ask. At a 30% tax rate, that deduction will be worth $1,500. Assuming the account holder invests all of hat money (and that’s a big assumption) in a taxable account, the $1,500 will grow to approximately $15,000 after 30 years. (Note that this is a best case scenario representing all capital gains, as any reinvested dividends would be taxed, thereby reducing that amount). But that investment growth will be subject to tax, so the after tax value would be much less.
This second example helps demonstrate why, for many account holders, a self-directed Roth IRA may be preferable to a traditional account.