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.
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!).
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:
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.