College graduates who are about to begin their careers will face an overwhelming number of financial choices, including how best to save for retirement. Consider: The newly employed have one or more retirement account options from which to choose, including Roth IRAs, traditional IRAs, and traditional 401(k) plans, that may or may not have a Roth 401(k) option, say the authors of a new paper on the subject. What’s more, many young workers likely have employers that provide a matching contribution, according Gregory Geisler, an associate professor of accounting at the University of Missouri Saint Louis and Jerry Stern, a professor of accounting at Indiana University-Bloomington.
So what’s the most tax-efficient way for those starting their work lives to build the biggest nest egg possible?
Well, there’s a three-step decision-making hierarchy to follow, according to Geisler and Stern’s paper, Retirement Account Options When Beginning a Career, which appeared in the May issue of the Journal of Financial Service Professionals. “And this hierarchy is what will make the individual wealthiest after considering taxes,” says Geisler.
Step 1. The best option for recent graduates is to contribute to a Roth 401(k) (or Roth 403(b)), at least enough to get the maximum matching contribution from your employer, according to Geisler and Stern.
If you don’t have the Roth 401(k) opportunity, Geisler and Stern recommend contributing to a traditional 401(k) up to the company match. To be sure, the maximum employer match varies widely, but the most common match is 50 cents for every dollar you contribute up to 6% of your salary. “Contribute enough to receive the maximum employer match,” Geisler and Stern wrote in their paper.
The authors note that contributions to Roth 401(k)s and Roth IRAs are made with after-tax dollars, that is, the contributions do not generate a tax deduction or exclusion. However, the big benefit to Roths is this: qualified withdrawals are not subject to tax — neither the contributions nor the earnings are taxed.
In contrast, contributions to traditional 401(k)s and deductible contributions to traditional IRAs are made with before-tax dollars and the contribution amounts are not taxed until they are withdrawn. What’s more, all of the earnings of traditional 401(k)s and traditional IRAs are subject to tax at withdrawal.
The reason for contributing first to a Roth 401(k) vs. a traditional 401(k) has to do with your current and your future tax brackets. “At the beginning of most white-collar careers, the individual’s marginal tax rate is significantly lower, for example the 15% federal tax bracket, than it will be when they are retired if they have consistently saved for retirement over their careers,” says Geisler. “Such an individual will probably be in the 25% rate bracket or higher when they are retired and are collecting Social Security and are taking distributions from their retirement accounts.”
In other words, distributions from your traditional 401(k) would be taxed at 25% while distributions from a Roth 401(k) won’t be taxed at all.
Assuming a $3,000 annual contribution by the employee and a matching $1,500 by the employer (which must be made to the employee’s 401(k)) that grows at 7% annually over the course of a 30-year career, the authors noted that a person would accumulate $416,926 after taxes if employee contributions were to a Roth 401(k) vs. $397,975 if to a traditional 401(k), assuming one’s marginal tax rate rises from 20% to 25% over their lifetime.
Step 2. Now, if there is no employer match or if you still have funds available after deferring enough of your salary to get the maximum 401(k) match, you should invest the maximum possible into a Roth IRA. For 2014, the maximum is $5,500 or $6,500 if age 50 or older.
Why do this? In short, you’ll have more investments from which to choose. “Even if there is a Roth 401(k) option, the reason for choosing a Roth IRA instead of unmatched contributions to a Roth 401(k) or traditional 401(k) is the availability of a wider variety of investment choices for a Roth IRA,” the authors wrote. “Thousands of mutual funds are available to an IRA investor.”
For instance, unlike most 401(k) plans, the authors say the money in an IRA can be invested in publicly traded stocks or bonds or exchange-traded funds (ETFs). Plus, there are no required minimum distribution (RMDs) with Roth IRAs. By contrast, RMDs must start by April 1 of the year after turning age 70½ for traditional IRAs, traditional 401(k)s, and Roth 401(k)s.
Step 3. And, lastly, if you have any money left to sock away for retirement, contribute as much as possible to your Roth 401(k). If you don’t have a Roth 401(k), invest whatever you can in a traditional 401(k).
According to the authors, one reason for setting aside money in Roth accounts has to do with what they call tax rate risk. “For Roth investments, regardless of whether tax rates are rising, falling, or remaining constant over time, employees can depend on their annualized after-tax rates of return and future after-tax values to be unaffected by changing marginal tax rates,” the authors wrote in their study.
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