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Why the Roth IRA Is the Ideal Long-Term Savings Vehicle for a Grad Student

May 31, 2017 by Emily

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You’re a graduate student with the means and desire to save for your future. What is the best way to do so? If you have taxable compensation, the Roth IRA is an awesome choice. IRAs confer long-term tax advantages so your money grows at its maximum possible rate. The Roth version of an IRA is very well-suited for people who currently have a lower income than they expect to have in retirement. And if you decide that your goal is not saving for retirement after all, you can still access your money!

Further reading: Even Grad Students Should Have a Roth IRA


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Tax Advantage of the IRA

If you keep your investments in a taxable account, whenever a taxable event occurs (like you sell an investment or receive a dividend) you will have to pay tax. Year after year, those taxes erode the gains in your account. In any given year, this may seem like a nibble, but when you consider that you will stay invested for decades, taxes become quite a big bite.

As a simplified example, compare the account balances of two people who invest $5,000 per year at a 10% rate of return over 40 years. The person whose account is not subject to tax ends with $2,434,259.06. The person who pays a 20% tax on the gains yearly ends with $1,398,905.20, 43% less!

The way to keep from paying tax on the gains in your account is to use a tax-advantaged retirement account. This deal does presume that you will not access your money until retirement (exceptions are below). There are many types of tax-advantaged retirement accounts out there, but they all depend on your workplace offering them to you or you being self-employed. Virtually no universities extend their 403(b) benefits to graduate students. Luckily, there is one tax-advantaged retirement account that is independent of your workplace or self-employment income, which is the IRA (Individual Retirement Arrangement).

The IRA is a wonderful vehicle to invest through. As it is independent, you can open this type of account at just about any brokerage firm and can put just about any type of investment inside of it. The world is your oyster when it comes to investment choice inside an IRA. In 2021, you can contribute up to $6,000 per year to an IRA.

You do need “taxable compensation” to contribute to an IRA. Starting in 2020, non-W-2 fellowship income is considered “compensation” for the purpose of contributing to an IRA. As long as your grad student stipend is taxable (it is for US citizens and residents, but may not be for non-residents covered by a tax treaty), it can be contributed to an IRA.

Further reading: Fellowship Income Is Now Eligible to Be Contributed to an IRA

Pay Tax Now, Not Later with the Roth

Tax-advantaged accounts currently come in two flavors: traditional and Roth. The main difference between the two is when you pay income tax on your money. While your money is inside the IRA, it grows tax-free, as discussed above. But you also get a tax break upon either contribution to or withdrawal from the account.

With a traditional IRA, you take an income tax deduction on the money you contribute to the account and pay ordinary income tax on the distributions you take in retirement. With a Roth IRA, you pay your full income tax on the money you contribute and do not pay income tax on the distributions.

When choosing between the traditional and Roth, the idea is to pay tax when you will be in a lower tax bracket. The typical graduate student has a low income during graduate school but expects a higher income later in life and in retirement. Therefore, the Roth option is the more popular for graduate students.

The Roth promises that you will pay tax on your IRA contribution now at your marginal income tax rate (likely 15% or lower) and never pay tax on that money again, no matter how much your investments grow!

Flexibility for Non-Retirement Goals

I’m an advocate of clearly defining your goals and choosing investments appropriate to your time horizon. For this reason, I think that you should only contribute to an IRA if you intend to use the money in retirement. But the Roth IRA rules allow for some flexibility. If the idea of absolutely not being able to use your investments for anything other than retirement is preventing you from starting to invest, you should know that you can access much of the money in your Roth IRA early should you change your mind about your goal.

Usually, when you pull money out of an IRA early, the distribution is subject to a 10% penalty. However, there are big exception categories for the Roth IRA. You can remove the contributions you made to your Roth IRA at any time without penalty. When it comes to your earnings, your distribution becomes qualified and therefore not penalized if you use it for the purchase of a first home (up to $10,000) or for higher education expenses.

So if you want to invest for the long-term but the idea of absolutely not being able to touch your money until retirement puts you off, rest easy that the Roth IRA is a great option for you. If your financial goals change in the next few years, you do have the ability to use the money in your Roth IRA for something other than retirement.

Between the tax-advantaged status, the option to pay tax now at a low rate and never again, and its flexibility to be used for multiple goals, the Roth IRA is just about a perfect retirement investing vehicle for graduate students! The only thing I would change about it is for the contribution limit to be higher. But grad students with taxable compensation have very good reasons to contribute to a Roth IRA

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Filed Under: Protect and Grow Wealth Tagged With: investing, Roth IRA

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