My Money Mistakes: IRAs and Student Loans

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Before I started this blog in late 2004, I didn’t know squat about managing my money besides not to spend it all. Although I’m sure I could have done much worse, let’s see where I was 5 years ago:

1) I didn’t max my IRAs out. Even though I was pretty broke and living on less than $20k a year, I should have tried to max them out. I think I only put $500 in my Traditional IRA for the first year, and $1000 the next.

2) Instead, I paid off my student loans. Even though I was still in grad school and therefore was paying no loan interest at all, I put all my excess money towards student loans even at the expense of not maxing out my IRAs. Think of all the tax-free gains I could have earned!

3) I used a Traditional IRA instead of Roth IRA. I was so focused on the measly tax break that I lost sight that I was barely in the 15% tax bracket. With the standard deduction and tuition credits, I might have even been in the 10% bracket. So I saved 10-15% in taxes back then, only to have to pay 25% in federal taxes this year when I convert it to a Roth. Doh!

If you’re young and in the 15% tax bracket or lower, contribute to a Roth IRA! The principal can be taken out any time penalty-free, and it’s got lots of other nice features.

4) I kept it all in cash. I had the “analysis paralysis”. I was so scared of losing all my money, I just put it in cash. So my IRA just sat there, shrinking with inflation.

All in all, it could have been worse, but it also could have been better. I’m sure I’ll remember more mistakes soon.

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  1. I agree. I could have paid off my less than $10k school loans already, but I am choosing to max out my Roth IRA’s instead.

    I locked in a fixed rate of 4.25% on my school loan; the returns on my Roth IRA’s over the last year have averaged much better than that.

  2. Hmm. Could you maybe explain the difference between an IRA and a Roth IRA, in glorious oversimplicity, for financial idiots such as myself who have read the official explanation before, and still don’t get it?

  3. IRA – account where you don’t have to pay capital gains taxes.

    Traditional – You get taxed on the money when you take it out (and thus get this years taxes reduced by the amount you put in)

    ROTH – You pay taxes before you put the money in. Then, withdrawls are tax-free.

  4. Clarification – You pay INCOME TAXES when you take money out of a traditional IRA, and not when you put it in.

    You pay INCOME TAXES on the money you put into a ROTH before you put it in, and not when you take it out.

    Put another way:
    Traditional – No tax going in. No tax on gains. Income Tax when it comes out.

    ROTH – Income tax when it is going in. No tax on gains. No tax when it comes out.

  5. Just a few additional points on the differences:

    Roth IRA:
    * Comes from money that’s already been taxed, so no tax break the year you contribute
    * As long as you wait until age 59.5 to redeem your earnings, they will never be taxed
    * You can redeem your principal (original investment) without penalty before retirement (although this would certainly reduce your tax-free earnings)
    * When you retire, it’s up to you when to start withdrawing money from it

    Traditional IRA:
    * get a tax break now on your contribution
    * pay tax on both the original investment and earnings when you redeem in retirement
    * The tax at that time will be your income tax rate (even if you were invested in stocks, for which long-term capital gains would otherwise be taxed at a lower rate)
    * You can only redeem your princpal without penalty under some very strict circumstances
    * The government starts requiring minimum withdrawls at retirement

  6. Dan points out something very important. Traditional IRA’s tax your earnings as income when you withdraw your money. Some prior posters stated that earnings are not taxed in the traditional IRA, which is wrong and an important difference between the two IRA options.

  7. Trivially easy question, but I think I had it wrong until very recently – do the yearly contribution maximums apply to your Roth and Traditional combined, or can you contribute the max to each one?

  8. Combined. So you can do 4k in Roth only, 4k in Traditional only, or 2k in both. (Or some other split that adds up to 4k unless you’re old enough to qualify for additional contributions)

  9. Is there a max total you can contribute to retirement plans? Im not sure, but someone told me that between IRA and 401k you can only contribute 15k. Is that true?

  10. Sure, paying for retirement ahead of low cost student loans is likely to pay off financially. But, there are some good intangible benefits to paying off your student loans early.
    For one, there is a nice psychological benefit to paying off the student loan and checking off the box. It gives you one less thing to worry about every month, and it feels rewarding to close that chapter based on the fruits of the education that you paid for. In addition, student loans are one category of debt that cannot be discharged in a bankruptcy, so a conservative strategy that erases that debt when you are able to pay it isn’t terrible. Heck, I also felt a twinge of social obligation to the student loan program to pay back the funds that were so generously made available to me… just seems like the right thing to do.

  11. I’ll be very upfront too, I have been questioning what is best for me for IRA accounts. 4K isn’t bad, but there is no way I know I could manage that much this year. (still being in college and paying 60%+ of my gross income to it because my parents make too much). So I also follow along with Pauls comment, the fact that School loans are the one thing that can’t be discharged by Bankruptcy, it is nice to know I will leave without them – and that I won’t ever have to worry of being in a bind and knowing I have to pay that stupid loan amount.

    As for determining what’s best for you, it can be very hard to detemine. Especially when you’re at the 25% or higher tax bracket. at max IRA contributions, that’s 1,000 tax break. But when you retire, will you even meet the filing requirements, will you be in the 10% tax bracket and not have to worry about it. Or will you still end up in the 25% tax bracket, and cringe when you have to pay your taxes. It’s all about planning and guessing about tax brackets. As for Jonathan, he said he wanted to earn I want to say 90K a year when retired, I’m sure that’ll put him back into the 25% or at least close to it by the time he hits that, in which case, Roth IRA would certainly be better for him. But you have to think on how you individually will do. If you’re earning and paying 28% or more, and spending it constantly, with no retirement other than your SSA (and again don’t bank on that!) and the measly IRA, than perhaps you are indeed best to contribute to a normal IRA. Under most circumstances however, from what I’ve heard it’s best for younger people to start in the Roth (Not to mention the best is you can withdraw from it for the purchase of your First home.)

  12. Good advice! I’m in college now and will soon be facing choices about whether or not to pay off loans or contribute to an IRA. Great blog, and I’ll be following it!

  13. If I have not max my 401K contribution, should I max out my 401k before worry about ROTH or traditional?

  14. I just did a post on mistakes too– I also did the thing of investing retirement money way too conservatively, back when I thought stocks were too voodoo for me!

  15. Nwang,

    Typically, the advice I’ve seen as far as priorities for people who qualify for both Roth & 401 is:

    1. max out the 401 at least to any MATCH your employer is offering (otherwise, you’re giving up the 100% return from their match!)

    2. pay off any high % debt, such as credit cards in which you’re paying high teens % in interest

    3. Then max out the Roth IRA

    4. Then max out the rest of your 401 beyond whatever match your employer offers

    5. If you’ve still got investment money left and no more tax-advantaged accounts to put it in, consider equities that don’t produce a lot of dividends (long-term capital gains grow tax deferred and then get better treatment when they finally are taxed) or I-Bonds (tax-deferred interest and state-tax free).

    Having both tax-deferred (401) and tax-free (Roth) retirement earnings is a way to hedge your bets on how your tax rate at retirement will compare to your tax rate now. So if the tax world is completely different in 30 years and your rate ends up being either double or half of your current rate, with both Roth and 401 you’ll have made the right bet on at least part of your assets either way.

  16. Forgot to say that #4 above is assuming you like the options in your 401. If you feel your employer’s offerings completely blow, skip to #5.

  17. What about if you are self-employed? (sole proprietor) I always see a lot of info about 401Ks, etc.. but not a lot of real info for those of us that are self-employed. Roth, SIMPLE, SEP? Which way to go?

  18. You sounds like me, I mean in my set of blunders and paralysis. I have few internet bubble sad stories to add to my woes.

    Good stuff..thanks

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