Saving for retirement when you're young is a prudent financial step.
But a new report shows young investors who put those savings into a Roth individual retirement account are making the smartest moves.
The study by T. Rowe Price found that a 25-year-old who uses a Roth IRA will retire with as much as 35 percent more spendable income than if he saved through a different type of retirement account. Even older investors, who have fewer years for earnings to grow, typically benefit.
The reason has to do with taxes.
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With traditional IRAs, you get a tax break on contributions you make. You also don't pay taxes on earnings while your money is invested. But the free ride eventually ends because income taxes are due when you begin to make withdrawals.
With a Roth, there's no upfront tax break. The money is put in after you've paid federal, state and local income taxes. But after that, earnings grow free of tax and withdrawals are tax-free too.
As a result, an investor who puts the maximum allowed per year in a Roth or traditional IRA could potentially end up with the same amount of money by retirement age (in both cases your savings are not being taxed as they grow).
But the money in a traditional IRA would not stretch as far in retirement because you will owe taxes on those dollars. A balance of $200,000, for example, would really be worth only about $170,000 if you're in the 15 percent federal income tax bracket.
And the difference becomes even more pronounced if tax rates increase or a rising income pushes you into a higher tax bracket.
According to the T. Rowe study, a 25-year-old could have 18 percent more spending income in retirement with a Roth account if his tax rate never changes. But if his tax rate goes from 15 percent to 25 percent, his spending dollars would rise by more than one-third.
T. Rowe's calculations even assume an investor takes the money saved from the upfront deduction on the traditional IRA and reinvests the cash in, say, stocks or bonds. But since you're likely using a standard brokerage account (where earnings get taxed), your money doesn't grow as quickly as it would in a retirement account.
Mary Ryan, a financial adviser in asset management services at Vanguard Group, said there are other reasons to consider a Roth over a traditional IRA.
For one, IRA withdrawals made before you turn age 59½ often incur a 10 percent penalty. You may also owe income taxes.
But if you have a Roth, Uncle Sam lets you use as much as $10,000 in savings if you've had the account for at least five years and you're using the funds to buy a first home. You may also be able to withdraw money penalty-free if you become disabled. And you can always withdraw contributions you've made to a Roth penalty- and tax-free.
"You have a lot of flexibility," Ryan said.