WHEN I STARTED working fulltime in 1980, there were very few retirement savings vehicles available to the average worker. I remember setting up my IRA and contributing the $2,000 annual maximum—at the time the only retirement account I could fund.
Today, by contrast, there’s a slew of retirement choices on offer. Where should those new to the workforce focus their dollars? If you have access to a 401(k) or similar retirement plan with an employer matching contribution, that’s the first place to stash your retirement savings. The match is free money and you don’t want to miss out.
If the company offers a Roth 401(k) account, put your money there—up to the level of the match—so you get the Roth’s tax-free growth. The company’s match, meanwhile, will go into the traditional 401(k), which means the money will be taxable when withdrawn. By saving in the Roth 401(k) and getting matched in the traditional 401(k), you’ll be diversifying across tax-free and tax-deferred accounts. In 2019, the maximum you can save in a 401(k) is $19,000 if you’re younger than age 50. The employer match doesn’t count toward this limit. There are no income restrictions on contributing to a 401(k).
If there’s no employer match in your employer’s plan, instead make funding a Roth IRA your top priority. You’ll have to set up the Roth IRA at a brokerage firm or mutual fund company. There are income limits that could potentially prevent you from funding a Roth IRA. But you can sidestep those limits with the so-called backdoor Roth: You establish a traditional IRA and then immediately convert it to a Roth.
In 2019, you can contribute $6,000 to all IRAs combined if you’re younger than age 50. Any contribution to a Roth IRA can be removed at any time, with no taxes or penalties owed, making it perfect for a backup emergency fund. This flexibility makes it more attractive than a Roth 401(k), unless your 401(k) contributions are earning you an employer match.
In addition to the Roth 401(k) and Roth IRA, you may have a high-deductible health insurance plan through your employer. That brings us to the third account that a new worker might establish: a health savings account, or HSA. If you’re under age 55, you can contribute $3,500—and that sum is tax-deductible, thus reducing the income taxes owed on your salary. On top of that, the money grows tax-deferred and—if it’s spent on medical expenses—will never be taxed. The super-saver will keep his or her medical receipts and not tap into the HSA for many years, and instead let the account continue to grow. When money is needed for any reason, the account holder can offset the amount withdrawn with those saved medical receipts, leaving him or her with tax-free money that can be used for any purpose.
If we ignore any employer match, the employee utilizing the above three accounts would be able to save $28,500 annually—and all the accounts might never be taxed. Realistically, few young adults who are just starting out will be saving at this level. After all, to hit that $28,500, you’d need to be earning $142,500 and saving 20% of income.
These various savings opportunities make my first annual $2,000 tax-deductible IRA contribution look small. Today, there are so many tax-free savings vehicles available to those who want to start saving early. Eventually, as you get into higher tax brackets, you might direct savings to tax-deductible 401(k) and IRA accounts, so you get the immediate tax break. But for most young adults, forgoing the tax deduction—and going for the tax-free growth—will be the way to go.
James McGlynn CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. His previous articles were As the Years Go By, Package Deals and Last Call.