tl;dr, Roth or traditional 401k
San son #3 starts a full time job this week with full benefits. He expects to make roughly $40k/year starting. The current pay for the top jobs that he can get without schooling are in the $55k range. He is covered under my health insurance and still lives at home so living expenses are controlled. The company withholds 3% and then matches it for a mandatory 401K. They will match an additional 3% plus any bonuses (typically 2-3%) can go there. He’ll fully vest in 3 years. He can contribute up to 50% per the benefits website. He has the option of either a tax-free 401k or a Roth 401k. I had always assumed a tax-free route is the best option but he is leaning towards the Roth. He pointed out paying taxes on $40k now is at a very low rate compared to what they might be in 30-40 years. He plans on banking this years pay to get a reliable vehicle and then next year to maximize to the extent possible his retirement contributions, until life and dating intervene.
Is he right about the Roth?
Is he correct about the taxes?
Does either option allow him to pull out for schooling, when it becomes viable? His employer will do some schooling reimbursement, for certain programs which ATM don’t interest him.
tl;dr, Roth or traditional 401k
“I had always assumed a tax-free route is the best option but he is leaning towards the Roth.”
401k and traditional IRA are not tax free but tax-deferred meaning he will pay the taxes on it when he withdraws the money at 65. Since it will probably be just that and social security then the taxes should be very low - even in 40 years. But you talked about tax-free. The gains from a Roth IRA are tax-free and if your son put in $1000 per quarter for 40 years at 4% interest they would have close to $400,000 having paid in $160,000 meaning they would have paid taxes on the $160,000 and have earned $240,000 tax-free.
If it were me and I could afford it, at 18 I would go Roth. The investment gain over the next 45 years he has until retirement is likely to be substantial. Tax brackets are an iffy thing because he has no idea what the government is going to do 50 years from now, so it’s hard to make an educated decision. Tax on the median income now is 25% which is the same as it was in 1968. However, tax on 3x the median income now is 28%. In 1968, it was 50%. So in 1968, it was way better to Roth due to tax brackets. Of course by the time you actually retired, not so much. Right now, the highest tax rate is about 40% which kicks in right around 7 times the median income. 7x the median income in 1968 would have hit you for 62% of your salary and the highest tax bracket was about 13x the median salary (equivalent today to about a little less than 800 thousand a year) and it was 70%.
That’s how tax cut politicians get you though. My wife and I make about twice the median income (110k a year) That puts us in the 25% bracket. In 1968 twice median income was 16 thousand, we would have been in the 28% bracket. So all of the ‘middle class tax cuts’ added up to about 3 thousand dollars a year for us. Which isn’t nothing. The ultrawealthy though are saving half of their old tax bill, literally millions upon millions a year that went into public coffers that benefit me and my children. It’s absolutely crazy to think about what the middle class mortgaged its soul for.
Anyway, I’ve gone off the path. The younger you are, if you can afford it, the better the advantages of a Roth.
I am not your financial adviser. Nor his.
In general, and without knowing more about your son, the likely best long-term option is for him to participate in the 401k to at least the level of match. Beyond that, he should be contributing to a Roth IRA to the maximum extent available. Right now that would be $5500/year. Do that at his age and the likelihood of his being able to retire early is very high.
tax-free vs tax-deferred:I understood that but failed to adequately express it.
You are not my financial adviser. Nor his.
How risky should his investments be at this age? Ride the market for all its worth or keep a sizable safe haven? Most likely somewhere in between I’d bet.
In all honesty, unless you want to monitor it, time will take care of him. Choose a good, cheap index fund - the 401k may not have one - and ride it to glory. Someone with 50 years until retirement can play it pretty vanilla.
PM me for specifics.
Whatever he decides, make sure he also understands about the fees charged for the different investment funds offered in the 401k. Many newbie investors ignore how much each fund charges for management and they don’t realize how big of an effect it will have. They may think fees of just 1-2% won’t matter, but those fees can take a huge chunk of their growth. Many newbie investors would do better with a simple index fund with very low fees (like an S&P index funds).
One nice thing about a Roth is that he won’t get hit by a huge tax implication if he needs to take out huge chunk out for a house, school, etc. For example, in retirement it is difficult to get a mortgage, so he may want to pay for a house with cash. If the money is in a Roth, there’s no tax implication. But if it’s a tax-deferred plan, like an IRA, he’ll owe taxes on the money as if it was income.
I think it’s also easier to pull the contribution amount out of a Roth before retirement if he needs. I think the growth has to stay in the Roth, but his actual contribution can be pulled out.
The counter-point to that is that he’s 18, so he can take an incredible amount of risk and still recover if the risk tanks. He can shoot for higher returns now and then mitigate the risk as he gets older. When I was in my 20s, I put almost all of my retirement into riskier global stocks. Some paid off, some didn’t. I ended up with around 15% returns as a whole. Fortunately, that was in the early 2000s and I turned 30 in 2008, so had moved a good portion of it into bonds before the shellacking we took. Of course, did I really make that much? Since you have so little saved in your 20s, the gains and losses are much smaller. Really you need to have at least 200k saved up before I think you even start to notice most bumps in the road.
Note my opening clause ‘unless you want to monitor it’. For some people, it becomes a hobby. For the vast VAST majority of people I know, most don’t want to fiddle with it at all. They just want to save and leave it be. They have other things taking up the processing cycles in their heads.
Here is a page from a short primer I wrote for a friend’s son who wanted to start saving for retirement.
It covers two points I wish I had known at the start of my working career
[li]Save early and often[/li][li]Minimize fees paid[/li][/ul]
Personally, I put my savings into a 401k when I was starting to work because I figured my retirement income would be in a lower bracket than my starting salary wa and so even if taxes went up my taxes would go down. I was making more than your son was though. At 45k i would guess his retirement bracket will be similar to what it is today. Our taxes are currently fairly low so i would bet on taxes going up over a career. So, I guess I’d recomend the Roth overall.
If there is a difference in the funds that he can invest in than I’d follow everyone else advice and pick based on fees since they will kill you in the long run.
I like **Jonathan Chance’s **advice. For the IRA, I’d go with one of Vanguard’s Target Retirement funds. If your son has money left over, he can shovel more into his 401(k), decide how to invest for his other priorities (car? house?), and/or maybe build up a little emergency fund in a money market fund. **jasg **has the right idea about how to pick investments.
Make sure he understands that stocks can drop in price quite sharply and for a prolonged period of time. At his age, the response to that should be excitement because everything is now on sale.
As for the tax rate after retirement, the thing is that you can control it to a certain extent, especially if you have post-tax savings. Plus, if your rate is low you can convert 401K money to Roth money depending on how the tax rates fall out.
As for investment direction does the employer offer a certain set of investments for the 401K? If so - and it was the case for all my employers - that limits his options.
I concur. Except for conglomerate stocks BRK.B and IEP my Roth is in ETFs that vary from Index/Industry to type (like growth or midcap) to high-risk/reward like MLPs. Once a quarter I look at my investments and based on their performance decide whether to modify what % of my portfolio is in each ETF. Other than that it is buy, drip, forget.
I have a separate portfolio for my “play” stocks.
Watch those fees on the Target funds. Some of them - especially the longer ones - can be relatively quite expensive.
Vanguard Target Retirement 2065 charges 0.15% annually. There is also a $20 account fee until the portfolio reaches $10,000, which he could meet with next year’s contribution. It’s hard to find anything equally diversified that is cheaper on an account that size.
Here are the other pages from the primer I wrote for my friend’s son. If anyone would like a PDF, pm me with your email.
I haven’t seen him to discuss all this yet.