Millions of students are working in college but are young and broke. This creates a once in a lifetime opportunity.
Retirement Accounts are perceived as complicated and only associated with an employer through a 401k. However, you can actually have your own and they are actually quite simple to understand. There are 2 main types of retirement accounts, the 401k and IRA. Both types have two subsections. How you make the decision between choosing which subsection you want will be reliant on your answer to the following question: Do you want to pay taxes now or later? However, first we must get the main types of accounts.
A 401k is an employer sponsored retirement account and will sometimes come with an employer match. This means that as you contribute a portion of your earnings toward this retirement account, the company may match that contribution to the account, essentially, doubling that part of your salary. The downside of this tax - deferred account is that your wages are taken straight out of your paycheck and you won't see it until you turn 59 ½. There is a 10% penalty to taking money out earlier than the 59 ½ mark, unless you use the rule of 55 which states: If you are laid off, fired or quit between the ages of 55-59 ½ you don't have to pay the 10% penalty to withdraw funds from your retirement account. (Rule of 55 only applies to 401k’s not IRA’s)
While the 401k is the most traditional, what happens if your work situation isn't so traditional? Working for a smaller company? Self Employed? Working part time? Freelancer? Contract worker? This is where the IRA or Individual Retirement Account comes in. This is not sponsored by an employer and you must take the initiative to go out and open one on your own. You 'll need some sort of earned income and obviously all the registration materials (social security number, employment information). There is also a monetary limit on the contribution that you can make to an IRA on any given year. Since 2019 it has been $6,000 or up to $7,000 if you are over 50 years old. Additionally, according to the IRS your contribution limit will begin to be phased out as you reach higher levels of income. (See Table Below) For example, individuals making more than $144,000 cannot contribute at all to an IRA. While these restrictions are important, they will not relate to most college students working a part time or even full time job. The vast majority will be able to contribute $6,000.
I mentioned that there are two types of accounts: a 401k and the IRA; the major difference being that the IRA is more geared toward those that are self-employed, while the 401k is usually offered by an employer. Within these types of accounts there is the ability to be able to choose when you would like to pay taxes. These are the two subsections. The first is the traditional IRA’s and 401k’s which are “tax deferred accounts.” This means that as you contribute to these accounts, whether it is straight out of your paycheck or you are contributing the $6,000 limit, you will not have to pay taxes on this earned income. According to the IRS, if you are not covered by a retirement plan at work, the entirety of your contribution to an IRA is tax deductible. This means that you simply subtract this contribution from your tax base. Basically, you keep the money but you don't have to pay taxes on it at the moment. This may benefit those who are in a high tax bracket when working. Remember that taxes are prorated, so this deduction that you take off the top will save you from paying the highest percentage in taxes. (EX. You make $100,000 - the first $10,275 of income is taxed at 10%, but that last $10,000 is taxed at 24%) While you avoid paying taxes now, you will eventually have to pay when you take money out of the account when you are retired. The thinking behind this is that you still will save money on taxes because your income will be close to zero when you are retired, effectively putting you in a much lower tax bracket when you withdraw. However, while you pay less taxes on your contribution, you will have to pay taxes on the capital gains in your account. Basically the difference between your total contribution and total account value will be considered your capital gains. So yes, those 40 years of profitable trades, great investments, dividends, earned interest - all of the profits from that, the government takes a flat fee off the top. These capital gains will be taxed as normal income. For example if you wanted to withdraw $20,000 of capital gains from your traditional IRA, this $20,000 will be treated as your income. Essentially, you will be paying income tax on money that wasn't even part of your income. (EX. Referencing the chart - your capital gains that you decide to withdraw over $10,275 and under $40,000 will be taxed at 12%)
Why is this important?
This once in a lifetime opportunity combines all the benefits of opening a Roth IRA. They are in (hopefully) the lowest tax bracket they will ever be in life, so it makes sense to take the tax burden now. They have the most time for their investments to grow, which can be done tax free. The contribution limitation doesn't really affect college students as most don't make much more than $6,000 a year. As college students may not have access to Roth 401k’s by employers, the clear choice is to set up a Roth IRA, contribute the max and grow your portfolio. When you turn 59 ½ all of the money that's been invested for 40 years will be able to be taken out tax free. This is the perfect time to set up a nest egg for retirement. Here's an example of what that can grow into*:
*Assumptions:
Annual interest rate of 10% - (Average return of the S&P is over 9% not including dividends)
40 Year Time Horizon - (Starting at 20 y/o and withdrawing when turning 60)
Ability to contribute 6,000 a year or $500 a month over the 40 year span after tax (this number will likely increase over the years - was 5,500 in 2017 / Also, once you are over 50 you will be able to contribute more - right now it is +$1,000)
Works Cited:
According to the national center for labor statistics (insert picture) https://nces.ed.gov/programs/coe/pdf/coe_ssa.pdf
Pictures:
Compound Interest Calculator https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator
Capital gains
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