My cousin is just starting out his first job. Advice from his parents, friends, and family? Start saving for retirement. But no one is giving him any help other than invest now, the market is low.
So should he do a Roth IRA or 401k? Well a Roth IRA is great if you qualify for it. You can save up to $5k/year of after tax dollars and it will grow tax free. Great. 30 years of compounding interest and growth without taxes! But you get a tax break if you invest in a 401k! Lower taxes now. Sure but when you are starting out it’s likely you’ll be in the lowest tax bracket ever.
What’s the problem?
Well I think a Roth IRA is the better option in general if there is no 401k match from your employer. Also for most people it’s a daunting task of setting up a Roth IRA account. Setting up auto-debit, and getting used to seeing the money disappear from your checking account.
Thus while it’s less effcient and effective, maybe a 401k is better. You can sign up through your workplace and no really do any extra paperwork other than checking the box yes and setting it to 10%. You don’t have to research your investment options unlike Roth IRA which anything and everything is available. Rather you have a limited number of mutual funds.
My DH has 9 mutual funds in his 401k, just the basic and people are auto enrolled. It’s more of a hassle to unenroll than just let it go. Also you can increase/decrease your contributions online at Fidelity’s website once you are enrolled. Because of the limited choices we invest in 4 mutual funds: S&P index, international, small cap, and mid cap fund.
But our Roth IRAs we control with ETFs and my DH actually tracks our investments. It takes a lot more time to manage and rebalance. His 401k? We rebalance once a year. We never worry since the money is deducted before he even sees his paycheck.
So my advice to my cousin? Sign up for the 401k at least minimally. It would be great if you were interested in the Roth IRA and are willing to set up the account. But rather than get caught not saving for retirement, do something (401k) rather than nothing.
What’s do you think?
13 responses so far ↓
1 savvy // Jul 13, 2009 at 9:30 am
If he gets a 401k match, he should definitely make the 401k his priority. Also, depending on his salary, traditional IRA contributions may be deductable. If that’s the case, I would definitely forego the Roth for now.
2 Angie // Jul 13, 2009 at 10:57 am
I would set up his 401k to the max so that he gets used to living on less from the very beginning. Then, when he has the time/energy/desire, he should open his Roth and start investing there (after making sure he continues to fund his 401k to the match point.)
He should also check to see if his company offers a Roth 401k. I know most don’t, but DH’s company has one and it allows us to contribute up to 16k instead of 5k like a Roth IRA. His company matches go into a traditional 401k.
3 LAL // Jul 13, 2009 at 12:23 pm
I don’t know about the match.
I know he doesn’t make enough to contribute the max Angie! Ouch! $16.5k is a lot to contribute right out of college.
4 Tessie // Jul 13, 2009 at 12:28 pm
That’s easy! Both! Oh, how I wish I’d done that when I was his age…it’s hard, but so worth it. Back then the maximum’s were something like $10,000 and $2,5000. Even on my measly salary I could’ve done it if I’d really tried. Yep. Don’t miss out on this opportunity.
5 JoeP // Jul 13, 2009 at 12:32 pm
Aren’t Roths supposed to benefit folks who get taxed highly, or for those close to the next income bracket? A traditional IRA may end up working out better in the long run, even being tax deferred.
6 tom // Jul 13, 2009 at 12:37 pm
I would do this order, automatic deduction if possible:
1. 401(k) up to company match, if any
2. Roth IRA up to Max
3. 401(k) up to max
7 LAL // Jul 13, 2009 at 1:37 pm
Tessie, if you make $50k gross i don’t think saving $21.5k/year or half your income is going to happen. Not with taxes, insurance, rent, eating, car payment, etc. Good in principal. Not so good in reality. I’m not even sure he’s making $50k.
Roths benefit people who are in a low tax bracket. If you are single and make around $100k you might not qualify. And you are in the 28% bracket anyway so it might not be worth it.
It depends on what you make mostly. But starting out it’s worth it.
But I think any retirement savings is better than none when you are 22!
8 Chris Miles // Jul 13, 2009 at 2:00 pm
If he really wants to make a dent towards his retirement (or anything in his life), then I would look for a 3rd option. I think he would potentially be in better shape in a normal money market than a 401k or IRA, especially since they have outperformed the markets for the last 12 + years. I wouldn’t recommend only investing in paper assets. With the right education, he could do much better outside of the stock market. Read http://www.fireyourfinancialadviser.com/blog/?p=196 and listen to http://www.fireyourfinancialadviser.com/blog/?p=86.
9 Meg // Jul 13, 2009 at 5:39 pm
I think it’s kind of insulting to any college graduate’s intelligence to assume that setting up a Roth IRA is somehow too complex to bother with. That’s the kind of pervasive mis-information that keeps people from trying to invest or save in the first place!
Setting up a Roth IRA online is easier than setting up an ebay account. And if you can figure out how to use an iPhone, you can figure out how to select your asset allocation (easy way: pick a Target Retirement Date fund; harder way: read a bunch of articles and study and analyze and finally come the the conclussion that you should pick a couple of broad index funds).
What he should do is contribute enough to get the 401k match and then put all he can into a Roth IRA beyond that. Tax rates will do NOTHING but go up from here, especially assuming he’s in the 25% bracket or lower. Settling for a tax deduction now when you could just pay 25% and never owe another penny on growth OR withdrawals will look downright silly in hindsight.
10 Meg // Jul 13, 2009 at 5:41 pm
PS – many companies offer a Roth 401k now. Most people don’t know the difference or whether their company offers one. Have him check that as it’s the simplest of all options!
11 Meg from FruWiki // Jul 13, 2009 at 6:05 pm
I actually have a question about IRAs that maybe someone here can answer.
If I remember correctly, Roth IRAs benefit those who plan to be in a higher tax bracket when they retire, whereas traditional IRAs benefit those who expect to be in a lower tax bracket, correct? In either case you pay taxes, it’s just a matter of when — and you’re hoping that when you pay you’ll pay less than you would have otherwise.
In which case, how come everyone says that Roth IRAs are so great? I’ve hardly heard ANYONE recommend a traditional. And most people really don’t go into much detail about why Roths are sooo much better. Is it just that they expect most people will be in a higher tax bracket when they retire? Personally, I can see my husband and I downsizing our income quite a bit before retiring, even if we go up in the meantime. Would we be better off with a Roth or traditional?
But whose to say what the taxes will be like then anyhow? How much is guaranteed and how much can we trust it? I don’t even know what OUR plans will be in 40 years (though hopefully we’ll be alive and well — even though those things aren’t guaranteed).
12 LAL // Jul 14, 2009 at 3:13 pm
Meg, intelligence? No. Laziness? Yes. It’s a lot more “effort” than many would bother doing.
Meg, the chances are the tax brackets are at all time lows right now under Bush. Second, you make more as you get older typically.
The plan is when you retire you typically replace 85% or 100% of income. So the taxes are a wash.
Personally? I like the Roth if you qualify for it. Meaning if you make too much for it, it’s likely you’ll be in a lower bracket when you retire because you’ll have sheltered money, etc.
13 Happy Money Medium // Jul 20, 2009 at 1:41 pm
I think “tom” in #6 has what is generally accepted as the “correct” sequence.
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