This is my contribution to The Roth IRA Movement started by Jeff Rose at Good Financial Cents. The post will briefly touch on the advantages of the Roth IRA account but will focus on how graduate students can determine whether or not they have earned income. For more posts with greater detail on various aspects of the Roth IRA, please visit the Movement’s page. Also, I am not a CPA or financial advisor, so please do your own research and consult with a professional!
Having, I’m sure, motivated you that saving for retirement while in graduate school is both beneficial and necessary, I’ll return to the recommendation I made at the end of the second post – the Roth IRA. First I’ll tell you why the Roth IRA is a great choice and then I’ll show you what I dug up concerning earned income, which is necessary to contribute to an IRA but that you may or may not have as a graduate student.
Why Should I Tie My Money Up in a Tax-Advantaged Account?
I’m going to assume that your retirement savings are actually meant for retirement, meaning you intend to not withdraw any money from them for several decades. You should have a separate emergency fund and savings for shorter-term goals like a house down payment. In that case, the government has given us amazing options to get out of paying taxes while our money is compounding with special tax-advantaged accounts
If you keep your retirement savings in a non-tax-advantaged account, you have to pay tax on your earnings every single year, like you do with a regular interest-bearing checking or savings account. If you think back to our compound interest example, you know that a small tweak in your rate of return can have massive implications after decades of compounding. Instead of earning a 10% rate of return, for instance, after taxes you will only have a (100 – tax rate)*10% rate of return. Right now I’m in the 15% federal tax bracket and 6% state, so I would only get a 7.9% return if my returns were taxed.
What can this mean over the long term? Let’s continue with our example of Jamie from my previous post (using the same calculator). For simplicity, let’s say Jamie has $16,000 at the end of her PhD that she invests in a tax-advantaged or non-tax advantaged account. She’s in the 25% federal tax bracket and pays 6% in state taxes as well. How will her money grow in each of these accounts over the 38 years until she retires?
No-brainer, right? Go for the tax-advantaged account!
What Kind of Tax Advantaged Account Should I Use?
As a graduate student you don’t have access to your university’s 401(k) or equivalent, so assuming you don’t have any other employers (including yourself), you are limited to IRAs for tax-advantaged retirement accounts. There are two types of IRAs available: traditional and Roth.
The major difference between the traditional and Roth IRAs is when the money is taxed. It’s true that the contributed money grows tax-free, but you will be taxed when you put it in or when you take it out. With a traditional IRA, you contribute money pre-tax and the withdrawals from the account are taxed. With a Roth IRA, you contribute money post-tax and the withdrawals are tax-free. So the first thing you have to ask yourself is: will your tax rate in retirement be higher or lower than it is now? You have to weigh your current income against your retirement income as well a guess whether overall tax rates will increase or decrease. For graduate students, the answer is almost certainly that our tax rates are lower now than they will be in retirement – at least, we all expect to be making lots more money post-graduation! So the Roth IRA is likely the better choice.
Briefly, there are some other features of the Roth IRA worth knowing about (for more detail, visit The Roth IRA Movement):
- You may only contribute earned income (more on this next) up to $5,000 per year (if under age 50).
- There are income limits for contributing the full $5,000 – your modified AGI must be less than $107,000 for singles and $169,000 for married filing jointly (no problem!).
- You can begin removing money from the account at age 59.5.
- Removing money early will result in taxes and penalties unless it is a qualified distribution, such as in the cases of death, disability, or buying a first home (up to $10,000).
What the Heck is Earned Income?
Note: What I’m about to cover is not well-understood among graduate students and there are many different opinions. I have talked with several administrators at my university about this issue and have called the IRS hotline a few times but still have not found a totally satisfactory explanation of the situation, especially from the IRS. You may not like what I conclude, and honestly I don’t like it either. If you disagree with what I’ve written or find it inaccurate in any way, please comment and I will look into your objections.
Roth IRA (and traditional IRA) contributions must be “earned income.”
“Earned income includes all the taxable income and wages you get from working. There are two ways to get earned income: You work for someone who pays you or you work in a business you own or run.” (source)
Basically, the IRS is trying to prevent people who don’t have any incomes other than interest and dividends, child support, unemployment benefits, etc. from participating in and benefitting from tax-advantaged accounts. You have to work for the money that you contribute! But of course we do work for our universities, and they pay us – right? Not so fast…
Unfortunately, and crazily, for graduate students, we can get caught up in this definition of non-work as well. Many graduate students are paid by fellowships – in fact, it is prestigious to be paid by a fellowship.
“Scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.” (IRS Publication 590 p. 7)
So if you are paid by a fellowship during the year and you receive something other than a W-2 at tax time (like a 1099-MISC), that pay does not count as earned income. If you receive a W-2, no matter if the source is a fellowship or a grant or something else, that is earned income.
Here is the really crazy part, from the instructions for the 1099-MISC:
“Do not use Form 1099-MISC to report scholarship or fellowship grants. Scholarship or fellowship grants that are taxable to the recipient because they are paid for teaching, research, or other services as a condition for receiving the grant are considered wages and must be reported on Form W-2. Other taxable scholarship or fellowship payments (to a degree or nondegree candidate) do not have to be reported by you to the IRS on any form.”
That means if you are paid by a 1099-MISC, your university is not paying you for any services such as teaching or research. There are not supposed to be any conditions requiring you to work for that money!
That is ludicrous and insulting. Of course we have to work to pursue our graduate degrees. We do research, we take classes, we teach. A PhD student woudn’t be retained by his program if he didn’t do the work expected of him, no matter how he was paid. We have the same jobs whether we receive 1099-MISCs or W-2s.
So perhaps there is a glimmer of hope for those receiving 1099-MISCs. Although I doubt your university’s very sophisticated tax professionals made a mistake, you could at least inquire at payroll as to why you received a 1099-MISC instead of a W-2. Perhaps (slim-to-nil, I imagine) there are conditions on your fellowship that you work and they should have given you a W-2 instead and you will be able to contribute to a Roth IRA.
In summary, here is how the way you are paid relates to your ability to contribute to a Roth IRA:
Remember that if, in a calendar year, you receive any earned income, you can contribute up to that amount to a Roth IRA. For instance, if the bulk of your pay comes in the form of a 1099-MISC but during one semester you were paid with a W-2 for teaching, you can contribute to a Roth IRA in that year, up to $5,000 or the amount you were paid on the W-2, whichever is less.
In my next post I will suggest ways that graduate students being paid with 1099-MISCs can save for the future despite their lack of earned income.
- Tax-advantaged retirement accounts can make your contributions grow super fast.
- Roth IRAs are great vehicles for graduate students with earned income.
- If you are paid by a W-2, you have earned income.
Did this post inspire you to contribute to a Roth IRA? What do you think about the earned income debate for fellowships?