For the young, Roth accounts are very smart ways to save money for retirement. That’s because they pay taxes on the contributed money up front, when their income is low, and can enjoy that money later without the Internal Revenue Service taking another slice. Traditional accounts defer taxes until retirement, when folks usually are in a much higher tax bracket than they were when starting out in life.
The subject is dear to me, as I know about young people and financial planning firsthand. This semester marks the end of six years of teaching at Purdue University. I love the students and I am honored to be the last educator they have before starting their careers in the field of financial planning. Undoubtedly, their parents and mentors care for them, as I am certain you do about the graduates in your life. Please help them to start saving in the right way.
Most of my students have a distinguished gentleman in their life that tells them to get a job and pay themselves first. That’s good advice. Normal words of wisdom they hear are: “Enroll in the company 401(k) and save all you can save as early as you can.”
But not so fast. This is not always the best guidance.
The key differences between a traditional savings plan – mainly a company-sponsored 401(k) – and a Roth vehicle, whether a 401(k) or an individual retirement account: The traditional types let you defer taxes on your contributions and any later investment gains. With the Roth alternatives, your contributions are after-tax, and you pay nothing on whatever the investment grows to when you withdraw it years later.
For most of the graduates, the effective tax rate is really very low – or zero – at the early stages of their careers. Thus, it makes more sense to contribute after-tax dollars to a Roth, and watch the investment grow tax-free for decades.
If you have an employer 401(k) plan with a reasonable match, you should contribute up to the match. Hopefully, the 401(k) plan offers a Roth option, and if so, you should go for that as opposed to the traditional version, where you make your contribution before tax – and years later as a retiree, pay taxes when you take out the money.
Source: USA Today | Joseph A. Clark, AdviceIQ