You’re out of college and landed your first job. Now what?

First, congratulations! If you believe the statistics consider yourself lucky to have overcome seriously competitive odds.  This real opportunity lets you put in place a few basic retirement goals.  The earlier you do it the easier it gets.

College graduates who are about to begin their careers will face an overwhelming number of financial choices, including how best to save for retirement.

The newly employed have one or more retirement account options from which to choose, including Roth IRAs, traditional IRAs, and traditional 401(k) plans, that may or may not have a Roth 401(k) option, say the authors of a new paper on the subject.

Many young workers likely have employers that provide a matching contribution, according Gregory Geisler, an associate professor of accounting at the University of Missouri Saint Louis and Jerry Stern, a professor of accounting at Indiana University-Bloomington.

So what’s the most tax-efficient way for those starting their work lives to build the biggest nest egg possible?

There is a three-step decision-making hierarchy to follow, according to Geisler and Stern’s paper, Retirement Account Options When Beginning a Career, which appeared in the May issue of the Journal of Financial Service Professionals.

“This hierarchy is what will make the individual wealthiest after considering taxes,” says Geisler.

Step 1. The best option for recent graduates is to contribute to a Roth 401(k) (or Roth 403(b)), at least enough to get the maximum matching contribution from your employer. Contributions to Roth 401(k)s and Roth IRAs are made with after-tax dollars, that is, the contributions do not generate a tax deduction or exclusion. However, the big benefit to Roths is this: qualified withdrawals are not subject to tax — neither the contributions nor the earnings are taxed.

The reason for contributing first to a Roth 401(k) vs. a traditional 401(k) has to do with your current and your future tax brackets. “At the beginning of most white-collar careers, the individual’s marginal tax rate is significantly lower, for example the 15% federal tax bracket, than it will be when they are retired if they have consistently saved for retirement over their careers,” says Geisler.  In other words, distributions from your traditional 401(k) would be taxed at 25% while distributions from a Roth 401(k) won’t be taxed at all.

Step 2. Now, if there is no employer match or if you still have funds available after deferring enough of your salary to get the maximum 401(k) match, you should invest the maximum possible into a Roth IRA. For 2014, the maximum is $5,500 or $6,500 if age 50 or older.

Why do this? In short, you’ll have more investments from which to choose. “Even if there is a Roth 401(k) option, the reason for choosing a Roth IRA instead of unmatched contributions to a Roth 401(k) or traditional 401(k) is the availability of a wider variety of investment choices for a Roth IRA,” the authors wrote. “Thousands of mutual funds are available to an IRA investor.”

Step 3. Lastly, if you have any money left to sock away for retirement, contribute as much as possible to your Roth 401(k). If you don’t have a Roth 401(k), invest whatever you can in a traditional 401(k).

The prime reason for setting aside money in Roth accounts has to do with what they call tax rate risk. For Roth investments, regardless of whether tax rates are rising, falling, or remaining constant over time, employees can depend on their annualized after-tax rates of return and future after-tax values to be unaffected by changing marginal tax rates.

For more information see FMi’s complete retirement planning options for young people here.

FM International Services (NY), Ltd. provides a wide range of retirement services featuring customized benefit plans, flexible investment options, and centralized pension administration. Through Fmi’s countless services, businesses of all sizes create unique domestic and international retirement plans for two employees or two thousand – with a single provider handling
conversion, setup, and administration.


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