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Many of my clients who are considering going to grad school ask me, “Which is better, a 401(k) or a Roth IRA?” Of course, in financial planning, every answer starts with “It depends.” We have a strategy that may make sense under certain circumstances, but as with any good plan, you need to make it in advance.
The short and sweet: If you are working now but plan to leave your employer and attend grad school full-time, you may want to consider contributing to your pre-tax 401(k) now and potentially converting it to a Roth IRA in the full year you are a student.
The long and important-to-understand: When you are first working, saving into a pre-tax 401(k) will reduce your taxable wages and therefore likely reduce your federal taxes. You’ll save in taxes at your marginal tax rate at that time. If you convert your pre-tax 401(k) to a Roth IRA, the amount of that conversion will increase your total income by the amount of the conversion.
As with any financial transaction, it is important to consult with a professional to ensure that the move from a 401(k) to any type of IRA or a particular strategy is appropriate for your situation. Both a 401(k) and a Roth IRA offer the potential for tax-deferred growth. A Roth IRA typically provides access to a broader range of investment options, but fees and expenses may also be higher. You should also consider your expected income and tax rates in retirement. If you expect your tax rate to be higher, a Roth IRA may be the better long-term choice.
Most two-year grad school programs run from the September of year one, through year two and end in May of year three. You’ll likely be working for parts of years one and three, but you may have little or no income in year two. When you have less income, you’ll likely find yourself in a lower tax bracket. This may be an excellent time to realize some income from a conversion, when your tax rate is low!
After grad school, you’ll hopefully be making more money than before—that’s why you went, right?—and therefore your tax rate may be higher. Qualified withdrawals from that Roth IRA (such as those made after age 59½) may be income tax-free. So, you’d save money by contributing at a middle tax bracket, pay money on the conversion at a lower tax rate and then withdraw money later in life tax-free despite your being in a higher tax bracket (and understanding, of course, that withdrawals prior to 59½ may result in a 10% IRS penalty tax).
Consider this hypothetical example: Jimmy’s first job gives him a taxable income of $50,000. In 2014, that taxable income would generate a tax bill of about $8,400. By contributing $9,000 to his pre-tax 401(k), he may save $2,250 in taxes (because he is in the 25% federal tax bracket). After working for two years and contributing to his 401(k), Jimmy enters grad school. At this point, he has saved $4,500 in taxes from two years of contributions. During his full year of grad school, he has no other income and he converts $18,000 from his 401(k) to a Roth IRA. After his standard deduction and personal exemption, his taxable income is about $9,000 and his federal tax bill is $900. He saved $4,500 in taxes, paid $900, and now his dollars can potentially grow tax-free for the rest of his life.
You need to plan ahead. Even though you may be in a low tax bracket at the time of the conversion, like Jimmy you’ll still probably have to pay taxes out of pocket. If that’s the case, you need to make sure you have money set aside for that tax bill. Also, depending on the specifics of your situation, such as if you have other deductions (like a mortgage) or income (like a summer job), the optimal amount to convert will vary.
The takeaway: If you plan on going to grad school, speak with your financial planner and/or tax advisor ahead of time and develop a plan to take advantage of your fluctuating tax bracket.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. It is suggested you discuss your specific situation with a qualified advisor.