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I'm an 18 year old college student in the US who has a job and decent savings that pays for school and expenses. I have two credit cards to start building credit, but as I start to investing after a long period of learning about it I want to open up some sort of retirement account as I keep hearing about how it's never too early. The problem is there are so many different types and each have complex rules and regulations. What types of accounts would it behoove me to investigate? For example, Roth IRA, IRA, 401k. Note that my employer will not be doing any type of matching and I'll be the only one depositing into it.

I make about $35K Annually.

  • Welcome to SE. A hint as to how much you're making would help. – JTP - Apologise to Monica Jan 6 '14 at 10:57
  • About 45 thousand annually. Right now the only bill I really have is school. – Jacob Jan 6 '14 at 12:22
  • I made a mistake above, 35 not 45. Trying to do things after being woken up in the middle of a sleep cycle can be bad. – Jacob Jan 6 '14 at 12:39
  • Does your employer offer a Roth 401K option or just a regular 401K? – JohnFx Jan 6 '14 at 15:38
  • A very similar question came up on Marketplace Money this week, marketplace.org/shows/marketplace-money/… . You want to listen to "Eric". He is young and in a similarly great financial situation, saving for retirement is great, but do not lose sight of other expenses that you will face as you strike out on your own that you could save for. – Freiheit Jan 6 '14 at 16:57
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This is way too broad to answer, and requires further inquiry into what your goals and risk tolerance levels are. So since we cannot answer your question directly, let me help you with writing up in short what the potential options are, and you can start doing your research from there.

Taxation considerations

"Retirement" accounts in the US are accounts created under various sections of the Internal Revenue Code (IRC) which allow deferral of income taxes to when you withdraw the amounts that deposited.

By depositing money into your retirement account you get a tax benefit that you can estimate based on your marginal tax rate: you're not paying income tax on the money deposited until you withdraw it from that account (that is what "deferred" means).

However, "Roth" versions are after-tax, i.e.: by depositing money you're not getting any current benefit. Instead - your qualified withdrawals are tax free in their entirety (including gains).

To Roth or not to Roth?

Generally speaking, if your current marginal tax rate is lower than what you expect it to be when you're retired - you would probably be better of with Roth accounts. Otherwise, Traditional accounts are more advantageous. Figuring this out though is not always easy, as it is difficult to estimate your retirement income now, and guessing what the tax rates would be. That said, if your current marginal tax rate is 15% or less, you're probably better off with Roth.

Penalties on early withdrawal

To discourage you from breaking your retirement savings, there's a penalty on early withdrawals from the retirement accounts (or earnings, from the Roth accounts), of 10% of the value (in addition to the ordinary tax you still need to pay). For Roth accounts, you only pay penalty and tax on the earnings.

What are the options?

401k - IRC section 401 defines a whole bunch of various tax-deferral schemes, subsection (k) talks about elective deferral of salary income. In short: you can elect to defer certain portion of your salary (up to $17500 as of 2013) for retirement and not pay income tax on it now (for Traditional 401k, for Roth it is taxed). Employers may or may not match, match isn't counted towards the $17500 limit (but there's a total limit of $52000 for all the 401k deposits on your behalf). Match is never Roth.

Solo 401k - if you're self employed, you can open a 401k plan as an employer of yourself.

IRA - this type of accounts doesn't require an employer co-operation, but does require earned income. You can deposit up to $5500 (2013) into a IRA per year, and reduce your taxable income by the deposited amount (if deposited in Traditional IRA).

SIMPLE and SEP IRA - If you're self-employed, this is another option which you can use to shift income taxes on your earnings into the future.

More resources

You can start with the Wikipedia page describing the US retirement plans, and check out the relevant information on the IRS web site.

Don't forget to look through the questions already asked and answered here on this topic.

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    +1 - I'm sticking with my age issue. At 18, he's near 100% certain to be making the lowest income of his life, esp working part time. Roth it is. If at 25, he marries, and decides the whole retirement account thing was a mistake, the withdrawal of deposits leaves him flexible. The pretax IRA becomes a bit more costly at that point, as he'd be in a higher bracket almost for sure. – JTP - Apologise to Monica Jan 6 '14 at 11:01
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The three you mentioned, the 401k, IRA, and Roth IRA, are the three most common options for workers in jobs requiring college degrees. Pensions are falling by the wayside for the average Joe, and the Roth 401k is still rare.

The simple answer is this; if your employer offers matching (yours doesn't, but this answer's for posterity and will help others), then contribute as much as you can to the 401(k), not to exceed the matching limit. So, if they offer 100% matching on contributions up to $5000, contribute $5000 if there's any way you can do so. By taking advantage of matching, you're effectively earning the matching percentage in the first year, and there aren't many investments that earn 100% APY.

Beyond that, invest as much as you can in an IRA (total IRA contribution limits for those under 50 are $5500 annually), and if you think you'll need more, consider investing more into the 401(k) (the remaining advantage of the employer plan over an IRA is that the federal contribution limits are really high, like $51,000 annually). Whether you choose a Traditional or a Roth is based on your answer to this question; do you think you are being taxed more or less today than you will be in 40 years? That can be a hard question to answer, but consider these facts:

  • Right this moment, as a single earner brand-new to the workforce, with no spouse, no kids, no mortgage, no medical problems and only your student debt interest to deduct, you will likely be paying a higher "effective rate" on your taxes now than you will at any other time during your working life (because you're making the least money you ever will, and with so few deductions it's mostly taxable). So, for now, it probably makes more sense to defer taxation of your retirement investments by putting it in an IRA or 401(k), even knowing that the government will get their cut of the interest as well.

  • Once you get married and have a couple of kids, your spouse will add a personal exemption of $3,950 (for TY2014) and a standard deduction of $6200 to your own exemption and deduction of the same amount, and your children will each allow you to deduct $3,950 as their personal exemption, plus each child gives you a $1000 tax credit (deducted from the amount of your taxes, not your income) so long as you qualify.

    You also get preferential income tax rates; the tables are calculated so that you are taxed as if your household income was the product of two equal earners, so if you're the sole breadwinner, you are taxed at rates based on you making half as much as you actually do. It doesn't work out to half the taxes, but it's still a big "marriage advantage".

    Lastly, you'll probably need to move out of the apartments and buy a house in the 'burbs, and pretty much everything except the principal portion of your house payments (interest, property taxes, PMI) is tax-deductible, as will be the portion of your children's hospital bills that your insurance doesn't cover, allowing you to exceed the standard deduction in itemized expenses for the first time. During this time, your "effective tax rate" will be the lowest it will ever be in your life, so you'll likely want to contribute to a Roth to take advantage.

  • As the kids grow up, you lose some of these advantages. The $1000 tax credit goes away as of the tax year that the child turns 16, and the personal exemption goes away when you're no longer supporting the majority of their financial needs. If you bought a house and got a mortgage, the interest you'll have paid on the loan each year will be reduced until you're paying mostly principal in the last 5 or so years. Medical expenses will likely increase over time, but you'll still be reasonably healthy into your 60s if you play your cards right, so your medical bills won't keep pace with the loss of deductions. The amount of interest your investments will earn between that time and retirement will also be relatively low, and you'll probably be trying to sock away every last penny you can to hit your retirement date. So, you'll likely need the tax-deferral and higher contribution limits (and hopefully employer matching) of a 401(k) and traditional IRA again during this time.

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Given the choice appears to boil down to Traditional IRA (pretax) or a Roth IRA, I'm going to focus on this. (Note - littleadv's answer was community wiki-worthy, I'm sure we'll refer to it for future questions.)

In 2013 there was a combined standard deduction and exemption of $10,000. And the 25% marginal bracket ends at a taxable $36,250. With nothing else coming into play, this means a gross $46,250 would put you right at the 25% line.

In my opinion, a college student making $35K should take advantage of the 15% bracket. In other words, pay the tax, use the Roth. As you move into a full time position, use the pre tax IRA to shield 25% money. Without an annual review of your situation, this is the best general advice I'd suggest.

(Edit)- You may wish to first understand Marginal Tax Rates. I wrote the article in '12, so the numbers may be $100 off, but the concept is important. I am at odds (respectfully, of course) with KiethS on the matter of Marginal vs Effective (or average) rate. Deposits to an IRA are made with respect to your marginal rate. If your taxable income were the $36K number I mentioned, any income above is taxed at 25%, but deductions putting you lower are at 15%. You are already $10K below this, definitely at 15%. Not my opinion. Fact. I can't know what you'll earn full time, but can guess 'more than now.' I can create a scenario in which you marry a stay at home mom (not judging, just running the numbers) and yes, get a huge mortgage, property tax, and three kids, and you drop to zero tax. What's more likely, is you graduate to a $60K+ income and are at 25% for quite sometime. Marry a working woman and hit 28%. There are times that effective rate is useful, but these decisions aren't made based on that, but at the margin. Finally, this year I will be at an effective 0%, yes, zero, but at a marginal 39% due to a series of phaseouts, carry-forward real estate loss, AMT etc. You can be sure I'll make my retirement numbers get me right on that line. The tax on the last $1000 of income is the only thing that matters in the decision.

At the back end, retirement, either 100% Roth or 100% pretax is not ideal. Using my general rule will help create a balance along the way. (And yes, I'm open minded to another general rule to be added to this to help fine tune it.)

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  • Keep in mind that total annual contribution limits for IRAs are pretty low; if he plans to sock away more than $5000 a year to retirement, no matter whether that money goes into a Roth or Traditional IRA, he'll have to put the remainder in a 401(k) at least for now. He can roll it over into his traditional IRA when he changes jobs. – KeithS Jan 7 '14 at 1:39
  • @KeithS - "My employer offers no retirement account whatsoever." Good advice, not an option. – JTP - Apologise to Monica Jan 7 '14 at 2:18

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