Graduating from college and entering the “real world” is an exciting and sometimes stressful time – you start your first job and begin an independent life in all respects, including handling all things financial. Most colleges don’t require any financial courses, and it’s not always easy to understand the how’s and why’s of investing, even if you understand many of the basics.
I received the following question from a recent college grad who is looking for more information about his retirement plan options:
I am a 22-year-old recent grad and have been confused about what IRA to invest in given my situation. I have a 401k plan with my employer which isn’t active until January 2019. My salary is $60,000.
However I started in July, so it will be much less – maybe $30,000. I want to put my money in a retirement fund. The traditional IRA will give me a tax deduction. However, for the 2019 year, I will have a 401k.
I wanted to have a Roth as well… that’s three different retirement funds. Is that too many/diversified? So many options… and which funds should I pick for my 401k, traditional, Roth and in what combination?
Thank you, Joseph.
Great question, Joseph. You’ve got several great things going for you right now, and it’s good to see you taking advantage of your opportunities while you are young. $60,000 is a very respectable salary, and with good financial management, you should be able to put yourself in a favorable financial position. Let’s look at a couple of your options.
Retirement Plan Options – 401k, Traditional IRA, and Roth IRA
These three options are the most commonly available tax-advantaged retirement plan options for most people (or the non-profit 403b or government Thrift Savings Plan in lieu of the 401k).
Before we go further, let’s give a quick explanation:
- 401k, 403B, TSP: Contributions are tax-deductible in the current year and are taxed when withdrawn in retirement.
- Traditional IRA: Contributions are tax-deductible in the current year and are taxed when withdrawn in retirement.
- Roth IRA: Contributions are not tax deductible in the current year and are not taxed when withdrawn in retirement. Learn more about Roth IRA Rules for withdrawal here!
Tax-advantaged retirement plans have specific rules regarding when you can make withdrawals, and there are contribution limits and income limits for some of these plans, which may affect your eligibility.
These resources can give you a better overview of what to expect when investing in retirement accounts (this information is essential for long-term planning!).
- Retirement account withdrawals – in general, you have to be age 59 ½ to make a withdrawal from your retirement account (there are a few exceptions, which are outside the scope of this article). Otherwise, your withdrawal may be subjected to early withdrawal penalties.
- Roth IRAs have specific income limits – earn too much, and you will not be eligible to contribute to a Roth IRA.
- Traditional IRAs are only deductible if your income falls below a certain limit.
- Learn more about Traditional and Roth IRA contribution limits and Traditional IRA Account Rules.
Pro Tip: Managing your 401(k) can be confusing. Utilizing a resource like Betterment can help ensure you get the most out of your retirement account.
Benefits of Tax Diversification in Retirement Plans
One of the advantages of opening a 401k or Traditional IRA is the tax deduction you can receive the year you earn the money. The money is contributed before taxes have been assessed and will grow without the drag of taxes until you withdraw it in retirement (assuming you don’t withdraw it early; see the link above regarding penalties).
Roth IRAs offer a different advantage – you pay taxes on the money now, the money will grow without the drag of taxes until it is withdrawn, and you will not pay any taxes when you withdraw it. So you pay taxes now for the benefit of not paying taxes later.
Having contributions in both types of plans will diversify your tax bill both now and in retirement, potentially giving you more flexibility in retirement.
This flexibility can be a huge benefit that allows you to withdraw extra funds without owing additional taxes.
Should Young Investors Choose a Traditional IRA or Roth IRA?
There are several good reasons why young people should consider a Roth IRA. Let’s start with taxes.
Most younger folks are earning less now than they will be when their careers progress, so they are probably in a lower tax bracket now than they will be later in their careers. So the benefit is paying taxes now at a lower rate and being able to make tax free withdrawals in retirement when their tax rate may be higher.
Another factor to consider is the unknown – we simply cannot predict what taxes will look like when we retire. Many people speculate that taxes will rise, and a Roth IRA provides a hedge against future tax rates because they offer tax-exempt withdrawals.
There are a couple of other benefits as well, including being able to make penalty-free early withdrawals under certain circumstances and no minimum distribution requirement, which is found with Traditional IRAs.
The main advantage of using a Traditional IRA is the tax break offered now, which can help reduce your tax bill. But this benefit is also available with a 401k plan.
A Roth offers the other side of the tax equation, which helps with tax diversification. Here is a Roth IRA and Traditional IRA comparison for more information about how the plans differ.
How Many Retirement Plan Accounts Can You Have?
This is a common question, and the answer is – it varies.
There is nothing wrong with opening a Traditional IRA and a Roth IRA and a 401k plan. You can even open multiple IRAs, and if you change companies, you can have more than one 401k plan.
But having multiple retirement accounts makes it more difficult to track your accounts and maintain an asset allocation that meets your needs. The best way to go is to open only the minimum number of accounts necessary to meet your needs.
You may be able to consolidate retirement plans if you change jobs or need to open another retirement account. [See How Many Retirement Accounts Can You Have? for more information about multiple retirement accounts].
Which Funds, How Should You Invest, and Where?
This is something I can’t answer directly. The best answer I can give is that you should invest based on your needs and risk tolerance.
To start with you will need to define your investment goals, then determine your risk tolerance. From there, you can settle upon an asset allocation that you are comfortable with.
*Note 401k plans and IRAs are vehicles for investments, they are not investments themselves. You can read more about this here: Where Do You Get the Best Roth IRA Rates?.
Where to open your IRA. You will open your 401k plan through your employer and fund it via payroll deductions. You will need to open your IRA through a qualified custodian, which could include an independent financial advisor, a bank, a discount brokerage firm, or a mutual fund house. Here is more information about how to start an IRA, and some of the best places to open an IRA.
Finally, I should offer this last reference article: Where Should You Invest First – 401(k) or IRA? This article covers how to maximize your retirement contributions to receive the max employer match and maximize your IRA contributions, should you decide to go with a Roth.
Best Places to Open an IRA
These two brokerages come highly recommended for IRA investing:
- Ally Invest: If you’re looking to invest in an IRA, you should probably consider Ally Invest. Ally Invest offers commission-free stock and ETF trades, which helps your investment money go a lot further!
- Betterment: Robo-advisors are all the rage right now, and Betterment is one of the reasons for that. Betterment is able to offer lower fees due to software and algorithm investment-management, which is attractive for many new investors, and those wanting a “set-it-and-forget-it” approach.
There is No Right or Wrong Way to Go
I hope you have a better idea of your options after reading this article and the referenced articles. As you can see, these plans offer many different advantages, disadvantages, and variables.
Personally, I am partial to investing in a Roth IRA when you are young and in a lower tax bracket. Taking a tax break now won’t give you a substantial benefit.
However, the long-term growth potential that compound interest provides could supercharge your Roth IRA – giving you a substantial nest egg that you can make tax-free withdrawals from in your retirement.
In the end, you will need to go with the plans and investments that best meet your needs and your risk tolerance. I recommend speaking with a professional, reading other sources, and thinking about your specific goals and needs. Best of luck, and congratulations on getting off to such a great start!
Readers – do you have any tips or comments to add?