Tip #1: New entrants to the workforce should immediately open a Roth IRA:
- Roth accounts double as an emergency fund and a retirement account because withdrawn contributions are not subject to tax or penalty. (Only investment returns are subject to tax and penalty.)
- A high school student with a part-time job may find it easier to save than a recent college graduate with student debt.
- Parents can fund the Roth IRA for a child with some W-2 earnings.
- Workers without access to a 401(k) plan can start saving for retirement through IRAs.
Additional information on advantages of opening a Roth IRA early in your career can be found here.
Tip #2: Roth retirement accounts are often preferable to conventional accounts:
- Choose a Roth contribution whenever your working year marginal tax rate is low, perhaps whenever the marginal tax rate is less than 25 percent.
- Roth disbursements reduce tax in retirement through two channels – (1) untaxed distributions and (2) lower tax on Social Security income.
- The lack of penalty or tax on Roth contributions makes the Roth account the better choice for households lacking emergency funds or households with high leverage.
- Households with high marginal tax rates and high levels of cash in relation to debt should choose the conventional retirement plan.
- The newly created Roth 401(k) plans allows workers to place contributions in a Roth and matching funds in a conventional account.
Additional information on why investors need to maximize their use of Roth retirement accounts can be found here.
Tip #3: Prioritize paying off your student loan over saving for retirement:
- Benefits from getting a head start on your student loan payments will likely exceed lost retirement income from early retirement plan contributions
- Rapid repayment of student loan debt reduces amount spent on interest over lifetime of loan.
- Inability to make all student loan payments on time will result in late fees.
- High debt levels and an inability to make on-time payments leads to higher costs on consumer loans, auto loans and mortgages.
- Student debt prevents many people from qualifying for a mortgage.
- Many new entrants to the workforce who choose to contribute to their 401(k) plan instead of rapidly repaying their student debt end up withdrawing 401(k) funds and paying penalty and tax.
This post makes the case that new entrants to the workforce must prioritize student debt repayment over saving for retirement in more detail.
Tip #4: Consider Income Driven Repayment (IDR) Loan options:
- There are advantages and disadvantages with IDR loans.
- IDR loans are sometimes the only feasible option when loan repayment starts.
- Some IDR borrowers will pay more over the life of their loan than borrowers with conventional loans.
- Changes in household income or marital status can cause people to switch from an IDR loan to a conventional loan.
- Married IDR borrowers must often file separate tax returns and pay higher taxes.
- IDR borrowers must annually recertify income and household size with loan servicers.
- Many IDR borrowers have not received timely IDR loan discharges because of borrower or loan servicer error.
- Several different IDR Loan programs exist, and choice of best program is complex.
- The newly enacted SAVE program will provide the lowest payment for many borrowers.
- The SAVE program will discourage some borrowers with a two-year degree from pursuing additional information.
- Changes in IDR programs and tax code will influence the cost of IDR loans.
Tip 5: Reallocate retirement savings from 401(k) plans to IRAs.
- Current rules favor the use of 401(k) plans over IRAs.
- IRA contributions are not always deductible if you or a spouse have a 401(k) plan and if your income is above a limit. Go here for discussion of these issues.
- The Secure Act 2.0 automatically enrolls workers in a 401(k) plan unless the worker opts out.
- Workers can rollover funds from a 401(k) plan to an IRA. Advantages of rollovers Include:
- Substantially higher retirement wealth due to lower fees.
- An increase in the number of investment options including fixed-income ladders and company stock. (Most 401(k) plans only allow investments in stock or bond ETFs.)
- Workers subject to vesting requirement may be better off with an IRA if vesting incentives lead workers to decline a better job offer.
- One attractive option is to take full advantage of an employer match to a 401(k) and invest additional funds in a Roth IRA.
- A Caveat: The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy. Whether IRAs are protected from creditors is determined by state law. ERISA, a national law, provides protection against creditors for 401(k) plans. This difference can persuade some people to keep funds in a 401(k) plan, rather than convert to an IRA. Go here for a state-by-state analysis of protections against creditors for owners of IRAs.
Go here for a discussion of the advantages associated with 401(k) rollovers.
Tip 6: Purchase some Series I Savings Bonds every year:
- Series I Savings bonds never fall in value and are backed by the full faith of the U.S. Treasury.
- Bonds cannot be redeemed until one year after issue.
- Redemptions prior to five years from issue date lead to forfeiture of one quarter of interest.
- The interest rate is based on two components – a fixed rate and the inflation rate
- The composite interest rate changes every six months but cannot fall below zero.
- The interest is taxed when the bond is redeemed.
- Bond matures and stops paying interest after 30 years.
- No fees on bonds purchased through Treasury Direct or through an IRS refund.
- Annual per person purchase limits are $10,000 directly through Treasury Direct, $5,000 through a tax refund with additional purchases allowed through a trust or business.
Useful information on the Series I Savings Bonds can be found here.
Tip 7: Convert traditional retirement assets to Roth assets when income is low.
- Conversion costs, a tax on the amount converted, are lowest when income and marginal tax rates are low.
- Conversions early in retirement prior to claiming Social Security are highly profitable.
Tip 8: Payoff the entire mortgage prior to retirement:
- Retirees with a mortgage obligation can’t reduce disbursements during a market downturn.
- Increased disbursements from retirement plans to cover a monthly mortgage payment leads to higher tax payments.
- Workers nearing retirement should prioritize paying off the mortgage over catch-up mortgage payments.