Retirement Accounts for the Future

Retirement Accounts for the Future

I recently wrote a post on individual retirement accounts in How to Fund Retirement and focused on three accounts available to college students. After graduation, however, even more possibilities will be available to students. It’s important to understand what these accounts are as well so you can start contributing to them as soon as you have access to them.

Let’s start from the one account I most wish I had access to:

 

401(k)

 

These accounts are tax-deferred like a Traditional IRA, meaning that you do not pay taxes on the money you put into the account, only the money you withdraw. You can start withdrawing at age 59.5 but have to start withdrawing at 70.5.* Unlike a Traditional IRA, 401(k)s have significantly higher contribution limits. In 2016, contribution limits for a 401(k) is $18,000 for those under 59.5 and just $5,500 for Traditional IRAs.

If you want access to your money before 59.5, you typically have to pay an extra 10% tax on top of income tax. Any withdrawals after 59.5, including the mandatory withdrawals after 70.5, are subject to income tax.

Typically you get a 401(k) through the company or organization you work for. Some companies are amazing and make 401(k)s even better by offering an employer match. This is basically free money, if there ever was such a thing, that employers commit to give based on an employee’s contributions. Say, for example, your employer says that they will contribute 3% of your salary to your 401(k). If you make $50,000 a year, then your employer is contributing $1,500 to your 401(k). Even better, employer matches do not count towards the employee’s contribution limit. So you can contribute up to the $18,000 limit and still receive an employer match.

It is also important to note that 401(k) plans vary from company to company. It really depends on who the company uses to help manage their employees’ retirement accounts. Some companies also do not offer an employee match.

Of course, if you go out on your own and start your own business, then you can always set up an individual 401(k). You would have the flexibility to determine which company you want to set up your 401(k) with and you can contribute both as an employee and an employer offering an employee match. Fun stuff.

Similar plans to a 401(k) that require working for a certain type of organization

 

The cousin of a 401(k) is a 403(b). A 403(b) is only for certain organizations, such as schools and non-profits, but provide basically the same services.

The second cousin would be the 401(a) Plan which requires employers to contribute to the 401(a). However, an employee is fully vested, meaning that they need to stay with the organization for a certain number of years to enjoy the benefits of employer contributions to their retirement account. This plan is also mainly for government or school employees.

A 457 Plan is also similar to a 401(k) plan, except better. While a 457 Plan is tax-deferred, there is no penalty for withdrawing your money before the age of 59.5 (other than paying mandatory income tax).

Furthermore, if your organization offers both a 457 Plan and a 401(k) or 403(b), then you can contribute the maximum contribution limits to both. For 2016, that means you could contribute a maximum of $36,000 a year.

The catch? This type of plan is exclusively offered to government employees and certain non-profits.

457 Plan: A perk of working for Uncle Sam

457 Plan: A perk of working for Uncle Sam

 

Roth 401(k)

 

A Roth 401(k) is pretty much the same as a 401(k), except contributions are taxed and withdrawals are tax-free. It is also possible to withdraw money from a Roth 401(k) early without any taxes if it counts as a qualified distribution (e.g. medical expenses).

 

SIMPLE IRA

 

The full name is Saving Incentive Match Plan for Employees Individual Retirement Account (they probably made the name fit to the acronym?). This are for small businesses with 100 or less employees. Contributions are tax-deferred and employers have to make some type of contribution even if employees do not.

 

SEP IRA

 

Any small business owner with less than 100 employees (even the owner is the only employee) can open up a SEP IRA (Simplified Employee Pension Individual Retirement Account). A SEP IRA, however, functions in the same domain as a Roth or Traditional IRA. This means that you can only contribute $5,500 to a SEP IRA, Roth IRA, and Traditional IRA altogether. If you put $5,500 into a SEP IRA, for example, then you cannot contribute to your Roth or traditional IRA for that tax year.

Typically, however, funding a SEP IRA is the employer’s responsibility and they can determine whether to contribute annually.

 

To compare each of these accounts more easily, check out this chart that focuses on the main retirement accounts**:

  401(k) Roth 401(k) SIMPLE IRA SEP IRA
Available to… An employee An employee Employee at small business (<100 employees) An employee
Contribution Limits (for 2016) $18,000 $18,000 $12,500 $5,500 (although the employer can contribute more)
Tax Benefits Tax-deferred Taxes on withdrawals Tax-deferred Tax-deferred
Employee Match Depends on company Depends on company Required Determined on an annual basis

Note: for all of these, your company needs to offer the plan in question. You cannot get a SIMPLE IRA if your organization offers a 401(k).

These are among the other retirement accounts that will be available to us college students after landing our first career. The option available to you will depend on where you end up working, but it is essential to be aware of the retirement accounts available to you. Should you change companies, however, or retire early, then it is possible to rollover any of these plans to a different type of individual retirement account, such as a Roth IRA. With these savings vehicles, you have the opportunity to save a lot of money on taxes while building a good nest egg for the future.

Nest egg hiding places for the future

Nest egg hiding places for the future

 

* I’m still at a loss as to why they are so set on the ½. 59.5. 70.5. Why aren’t the numbers just rounded instead of making people figure out when they are halfway to 60 or 71? If someone would like to reveal this mystery for me, I would be extremely grateful.

**Check out the “Similar Plans to 401(k)” section to see more specialized retirement options. I left them out of the chart, however, since they aren’t readily available to everyone.

 

I left out some retirement accounts, for the sake of brevity (or ignorance). If you have any others to share, please do so in the comments below!

How to Fund Retirement

How to Fund Retirement

There are 47 or so years left until retirement for the typical college freshman, which is more than twice the 18 or so years we have had so far. A lot can change between now and then: our dreams, health condition, financial situation. The myriad of “what-if” situations are dizzying and who honestly wants to consider retirement as a college student?

With so much uncertainty for the coming decades, it is important to be aware of the different savings vehicles available for retirement. No one wants their hard earned money to be eaten away by inflation or taxes.

Fortunately, in the United States, there is a retirement vehicle that can dodge both of those problems: tax-sheltered retirement accounts. These types of accounts share three important characteristics that make them ideal vehicles for saving a nest egg:

 

  • Invest in the Stock Market

Putting all of your retirement cash in a savings account (or worse, a checking account) is subjecting it to a painful, lonely death by inflation. The dismal 1% interest (and often less) isn’t a worthy investment. It would take 70 years just for your initial deposit to double in value, and that’s not even factoring in the damage done by inflation.

Retirement accounts, however, allow you to invest in the stock market, where you have the potential to get higher returns and have a better chance at beating inflation. Careful consideration is required to invest in stocks and bonds, but you will never be financially secure just sitting on a pile of cash if the cost of living rises.

 

  • Tax-Sheltered: No Capital Gains Tax on Earnings

Retirement accounts are set up by the government, and as such, have special protections from a typical brokerage account. Whenever you make money selling shares of a stock in a normal brokerage account, there are capital gains taxes that eat into your profits.* Whenever you buy a stock that pays dividends, the dividends are taxed as well.

Not so in a retirement account. You can buy and sell stocks without worrying about taxes on any earnings. This is an enormous advantage when saving for retirement, as capital gains taxes alone can take anywhere from 15-20% of your profits.

 

  • Additional Tax Benefits

Depending on the type of retirement account, you do not have to pay taxes when you put money into the account or when you take it out. In either case, you do pay taxes at some point—either when you withdraw or deposit respectively—but both scenarios have their advantages.

 

Retirement accounts are great savings vehicles for the future, but they also are not perfect. The two major drawbacks are contribution limits and withdrawal limits. Contribution limits are determined by the IRS annually** and set the amount you can deposit in a retirement account per year. You also cannot contribute more than you make. If you make, say $2000 from work-study and put all of it into your Roth IRA (see below for details), and your lovely grandmother gives you $50 for your birthday, then you cannot put that $50 into your account. Since you only made $2000, you cannot contribute $2050, even if the contribution limit for 2016 is $5500 for a Roth IRA. Withdrawal limits, on the other hand, prevent you from withdrawing all of your retirement money before the usual retirement age. Often times, you have to wait until you are 59.5 to access the earnings from dividends and selling shares.

While there are multiple different types of retirement accounts, college students without a steady job can only take advantage of a certain few. There are three individual retirement accounts that U.S. college students*** can start funding for the future:

 

Traditional IRA (Individual Retirement Arrangements)

 

A traditional IRA is tax-deferred, meaning whatever amount you contribute is only taxed when you withdraw the money. Whenever you contribute to a traditional IRA your taxable income also lowers correspondingly. This means that you can pay less taxes when contributing to a traditional IRA (in addition to paying no initial taxes on the amount you contribute) and only pay income tax on the money you withdraw later in life.

However, you can only withdraw money without a tax penalty (usually a 10% tax on top of income tax) when you are 59.5 as well as start withdrawing money (a.k.a. required minimum distributions) at 70.5 to avoid an extra 50% tax. You cannot keep your money in a traditional IRA forever, after all, since the government does eventually want their tax dollars.

 

Roth IRA

 

A Roth IRA is a traditional IRA’s opposite twin. While they both are protected from capital gains tax, the similarities stop there. All contributions to a Roth IRA are taxed upfront and there are no required minimum distributions at any age. Any money withdrawn from a Roth IRA after 59.5, however, is not taxed.

Another useful feature of Roth IRAs is that you can withdraw the amount you contributed without a tax penalty. There are some tricks to doing this, such as withdrawing the amount you contributed for that year. Note that this specifically excludes withdrawing any money made from investing in the Roth IRA, but there are also some tricks to getting that money out as well (stay tuned for a future post on this!).

 

myRA

 

A myRA is like the starter pack for a Roth IRA. In fact, after myRA account reaches $15,000 or its 30th birthday, the money automatically transfers into a Roth IRA.

Like the Roth IRA, any contributions to a myRA are taxed upfront but not taxed at withdrawal.

myRA’s, however, are severely limited as retirement accounts since it only invests in US treasury bonds, which makes it a glorified savings account in terms of investing. Currently, the highest interest rate on a US 30-year treasury bond is 2.3%, which would take 30.5 years to double any amount of money. The main advantages of a myRA is that it can easily be converted into a Roth IRA and doesn’t require a set starting contribution. Brokerages sometimes ask for a set amount to be in a Roth or Traditional IRA that people like college students just don’t have saved up. Thus, the idea behind the myRA is that it can ease someone just starting out into a Roth IRA.

With a little research, however, you can find a traditional or Roth IRA account that does not require a starting contribution. You will still have to pay fees to buying and selling stocks, but you have better and more diverse investment options.

If you are considering a myRA, my advice is to convert it into a Roth IRA as soon as you have enough to do so. Check with the brokerage firm you want to set up your Roth IRA with, save like crazy, convert that myRA into a Roth IRA, and finally start investing in something with better return.

To summarize all of this:

 

irapost

 

With all this time to fully enjoy the benefits of compound interest, the next natural question is where to put the money. While options are limited for college students, we can still invest in our future by maintaining an individual retirement account.

 

 

*No capital gains tax also means you cannot tax loss harvest in a retirement account. If you want to learn more about tax loss harvesting, check out the MadFIentist’s post on tax loss harvesting.

**Sometimes the amount you can contribute to a certain retirement account is limited by income level. A Roth IRA, for example, is unavailable for someone making more than $132,000. I highly doubt, however, that person would be a typical college student.

***International students can also open IRAs.