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 The company’s match, meanwhile, will go into the traditional 401(k), which means the money will be taxable when withdrawn.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.
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To me it’s not so clear-cut whether a Traditional or Roth IRA is the better choice. I agree that diversifying across both tax-free and tax-deferred accounts is probably a good idea since we don’t know how tax laws will change in the future. However, if we only look at the cold, hard numbers, technically a traditional IRA is the better option if one is aiming for early retirement: https://www.madfientist.com/traditional-ira-vs-roth-ira/
For new workers in a low tax bracket can’t beat the Roth versus traditional IRA. There is not much benefit to getting a tax break at 20% or lower. The real benefit comes when the brackets are higher. At that time traditional is more appealing. Yes tax laws will change and Roth might get dinged but the traditional IRA will be subject to any tax increases Congress passes on ordinary income. I did mention that with a match you can 401k Roth and the match money will go traditional for diversification.
A traditional IRA may be a better option if you are aiming to retire early, but I diversify across regular and Roth accounts simply to have options in retirement as I don’t know what the tax laws will be in the future either. Congress may change how Roth accounts are treated for tax purposes in the future, but every dollar in a traditional account will be “subject” to tax. I don’t think that will change.
Add me to the list of Roth matchers. I much prefer this skin-in-the-game approach vs. outright gifts. I do it for my kids and their family’s up to their contribution limits. I told them I’ll do this as long as I’m able and all of us hope it’ll never end.
On the possibility of congress changing the Roth rules without grandfathering previous contributions – I seriously doubt they would try it, and if they did – get away with it. Mark Twain would have said I’m being too generous, but investing is all about making your best guess and that’s mine.
James – I’ve told my high school grandkids that I’ll match any reportable earnings they make with a matching contribution up to $2000 into a Roth IRA. Does this make sense? I appreciate any highly qualified and accredited free financial advice and response you can give me.
David – that is certainly a great idea. I would do it for my grandchild, but she is only 3 years old at the moment. Just remember the total contribution cannot exceed the earned income. In simple terms, assume the grandchild earned $2000 and saved $1000 for the Roth. You could match $1000 for a total of $2000. If they earned $5000, saved $2000 themselves, you could then match $2000 as the total is less than the earned income. Hope these examples help.
I do the same for my older kids too! Only thing better than free money is free money growing tax-free!
“There are no income restrictions on contributing to a 401(k).”
Not necessarily. If you’re a “highly compensated employee” (HCE) you may be limited in what you can contribute if there isn’t enough (or high enough) participation in your employers 401K program.
There are no income restrictions but in that case there would be contribution limits.