03 Apr IRA options for young investors

Q. I’m 26 working for the county with pension. Which would be better — a Roth or traditional IRA? My only fear is that contributions would take money away from me to do things like pay more towards my student loans.
— Wanting to save

A. We’re so glad to see you’re on the right track. Your smart question proves it.

At 26, time is on your side and the benefits of investing early will be magnified as time goes on.

But first, you need to manage your cash flow in order to pay your living expenses and manage your debt.

You’ll want to avoid making contributions to an IRA if it comes at the expense of making payments on your student loans, said Chadderdon O’Brien, a certified financial planner with RegentAtlantic in Morristown.

But, he said, if you find your month-to-month cash flow allows you to pay your bills and student loans and still have something left over, directing this excess amount to a savings strategy can make a lot of sense.

Before beginning IRA contributions, O’Brien recommends you first save enough “safety cash” to cover large unexpected expenses above and beyond what your normal cash flow could support. This will help you avoid going into debt should an unexpected expense pop up.

“A general rule of thumb is to maintain three to six months of income in cash, however, this is not appropriate for everyone,” he said. “Depending on your income and other resources available to you, you should target a number that makes sense for you.”

Once you’re able to check that item off your list, you can move onto retirement savings.

To decide on Roth or traditional IRA contributions, let’s first review the basic rules and features of each.

For 2017, you’re eligible to contribute up to $5,500 into either type of IRA, O’Brien said.

Single filing tax payers are permitted to make direct Roth IRA contributions so long as their total income is below $118,000. A contribution into a Roth IRA is not a deductible item on your tax return, but once money is in a Roth, all future growth will be distributed tax-free as long as future distributions are deemed qualified, he said.

Traditional IRAs, on the other hand, receive an immediate tax deduction for the year of the contribution, O’Brien said.

There are some limits to the deductibility of the contribution if you participate in an employer sponsored retirement plan and have income above $62,000 as a single filer, O’Brien said. There is no limit to the deductibility of contributions for single filers not participating in an employer sponsored plan.

Qualified distributions from the traditional IRA are taxed as ordinary income at the time you take it out, and unlike traditional IRAs, Roth IRAs do not require the account owner to begin taking distributions at age 70 1/2, he said.

For illustrative purposes, let’s assume you’re eligible to make a Roth IRA contribution and would also receive a full deduction on a traditional IRA contribution. Which is more valuable to you?

“When time is on your side, oftentimes Roth contributions make the most sense because of the Roth’s ability to distribute growth tax-free,” O’Brien said. “Over many decades, a Roth account invested relatively aggressively will likely generate a significant amount of growth. This is an especially relevant point given your situation.”

If it is reasonable to assume you’ll continue working for the county and will eventually receive a fixed pension benefit, it is also reasonable to have a more aggressive tilt towards your investments, O’Brien said. That’s because the pension can be viewed as a low-risk investment.

“In order to have a more moderate approach to your retirement planning your Roth account can be more aggressive to balance your risk,” he said.

Roth accounts can also make a lot of sense if you believe your tax rate in retirement, or when IRA distributions begin, will not be significantly lower than your tax rate today, O’Brien said.

“There is no way to know what tax policy and rates will look like in 40 years. We can, however, assume that since you’ll be receiving a pension your income in retirement may be very similar to your income during your working years,” he said. “With this is mind, foregoing the deduction today makes sense in order to receive tax free distributions in the future.”

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This post was first published on April 3, 2017.