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3 Reasons a Roth IRA Is a Smart Way to Save in Your 20s

Jordan Wathen, The Motley Fool

Think of Roth IRAs (individual retirement accounts) as a special type of piggy bank. You can put money into them, up to $5,500 this year for people who are younger than 50, and give the money special super powers, like the power to dodge taxes later when you withdraw your principal and gains in retirement.

If you choose to invest in a Roth IRA, you can get even more advantages, like the ability to make large withdrawals for buying a home when you're ready. For this reason, younger savers may be better off with a Roth IRA than any other retirement account. Here's why.

1. Tax advantages

Taxes are boring, but saving money on them certainly isn't. People in their 20s are likely to be in a lower tax bracket now than they will be in retirement. That means that it makes sense to pay taxes now to avoid taxes on withdrawals later.

Suppose you're in the early years of your career, naturally expecting your earnings to increase over time. Right now, you might be in the 12% marginal tax bracket. At retirement, you might be in the 22% marginal tax bracket. By investing in a Roth IRA now, you're essentially paying 12% taxes today on your contributions to avoid paying a 22% tax rate on the money you withdraw from the Roth IRA decades from now.

Of course, no one knows what tax rates might be 30 or 40 years from now, but the certainty of knowing that a $50,000 Roth IRA balance means you'll actually have $50,000 when you withdraw can be a big advantage.

$100 bills in a transparent glass jar.

Image source: Getty Images.

2. A great tool for saving for a home

A Roth IRA can be an excellent account to sock money away for a home purchase. Because a Roth IRA is funded with post-tax dollars, you can withdraw your contributions (principal you put in) for any reason, at any time, without paying a dime in taxes or penalties.

First-time homebuyers (defined as people who haven't owned a home in the past two years) can also withdraw up to $10,000 of investment gains on top of their contributions, tax and penalty free, as long as the Roth IRA was open for at least five years. That's a win.

Suppose you graduated college and started investing in a Roth IRA at the start of 2013. You made monthly contributions, contributing a total of $5,500 to your Roth IRA each year from 2013 to 2017, putting all of your money in an S&P 500 index fund to let the stock market work its magic for you. 

In the five years up to December 2017, you would have contributed $27,500 in total. But your account would now be worth $37,566, thanks to the general increase in stock prices over time, according to one calculator. If you wanted to, you could withdraw up to $27,500 (your original investment) without paying anything in penalties or taxes on it.

In addition, you could also withdraw $10,000 of gains to buy a home, tax and penalty free, all because your Roth has been open for five full years (you opened the account in the 2013 tax year for a home purchase in the 2018 tax year). That gives you a big down payment (up to $37,500 in this case) to buy a home in most of the country.

To be fair to traditional IRAs, they also allow you to withdraw money to buy a home penalty-free, but not tax free, and only in an amount up to $10,000. For people who live in higher-priced housing markets, a Roth IRA may make way more sense just for this reason.

3. Choices matter

Look, you shouldn't gamble away your money in penny stocks, or trade your IRA as if you're sitting on a trading desk in a big bank. But the truth is that one of the most valuable features of an IRA -- Roth or traditional IRAs -- is that you have a lot more choices about how you invest.

Want to buy individual stocks? You can do that. Want to buy one of the 2,000 exchange-traded funds (ETFs) out there? You can do that, too.

In a world where employer-sponsored plans like 401(K)s offer fewer than 30 choices, many of them duplicates, the flexibility offered by an IRA is unmatched. If you want to carve out a small percentage of your portfolio to pick a few stocks on your own to buy and hold, I think it's something worth doing, if only for the learning experience.

There's a lot to be said for taking an active role in capitalism, owning pieces of companies you believe in and want to follow more closely. And an IRA, Roth or traditional, is one of the few accounts where the whole financial world is really your oyster.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.