Avoiding taxes

Kinds of retirement accounts

As a grad student, you pay around 15 cents on the dollar in federal income taxes (after deductions and exemptions). If you invest some of your salary, you'll have to pay another 15 cents in taxes on every additional dollar you make. So, if you put in your $500 a month to an ordinary mutual fund and it grows to $1.1 million, you won't actually quite be a millionaire because you will have had to give Uncle Sam his share of the nearly $900,000 in gains. That's a lot of taxes.

That's where “tax-advantaged” retirement accounts come in. A “tax-advantaged” account is a label you slap on a particular investment you make – stocks, bonds, gold, a savings account, whatever – which gives you special tax treatment as long as you leave the money invested until retirement. As a graduate student you have three of these kinds of accounts available to you. For now, you'll want the Roth IRA, but here's how they all work.

A Roth IRA is fundamentally simple: when you retire and take your money out of a Roth IRA account, it's tax free. You get to keep your million. Beautiful. You can think of this as the government effectively kicking in the tax towards your retirement. This is what you should do. Take however much you can spare on a monthly basis and contribute it automatically from your checking account into a mutual fund. Some mutual fund companies, like T. Rowe Price, will let you start with only $50/month. You can contribute up to a combined $5000/yr to all IRAs. For detailed information on the mechanics of Roth IRAs, there's a great website here.

A traditional IRA allows you to deduct any money you invest from your taxable income on your tax forms in the year you invest it (even if you don't itemize your deductions), but you still pay taxes when you take it out. In effect, the government kicks in the tax like for a Roth, but it does it now, instead of when you take it out. This is called a “tax-deferred” account. The bottom line is that for young folks like us, the Roth is always better, for reasons I get into below. You can contribute up to a combined $5000/yr to all IRAs.

cal.jpg Unless you're on a big fat fellowship or not a California resident, you're probably already contributing to a third kind of “tax-advantaged” account: a 401(a) which Cal calls “DCP”. This plan is a lot like a traditional IRA, except it's mandatory and the money comes right out of your paycheck (before it's taxed). Every summer you earn wages you are forced to contribute to this “Defined Contribution Plan”. If you don't take action, these contributions will accumulate 1٪ APY in a “short-term” account at Fidelity, who will send you a quarterly report in the mail on how “well” it's doing. To make the most of it, go to the website and move your DCP money to mutual funds (the Spartan 500 index fund is a good option they offer) so you earn some substantial returns, instead of only 1٪.

cal.jpg And that's it. As a grad student you can save up to $5000/yr in a “tax-advantaged” way, plus whatever you are forced to contribute to DCP. If you manage to save more than that, you'll have to do it in a regular, taxable account. Cal offers some employees retirement plans, including voluntary, after-tax contributions to DCP for postdocs. Students only qualify for these plans if they work at least 50٪ for a whole year, which we usually don't. When you graduate, your new employer (even if it's UC) may offer other kinds of plans (see below).

After Grad School: Saving your DCP money

cal.jpg So you've graduated and you'd like to keep the 3٪ of your summer salaries that the University has diligently socked away for you at Fidelity. What do you do? It turns out that you can simply call Fidelity and ask them to change the account over to a “rollover” IRA (which is just an IRA started with cash from a different kind of retirement account). Thirty days after you formally terminate your employment with Berkeley, inform your favorite financial services company (such as Vanguard, T. Rowe Price, Fidelity, or whoever is handling your IRAs) that you'd like to roll over your existing 401(a) plan into an IRA. They'll gladly walk you through the steps. Ideally, you'll perform what's called a “direct rollover” where Fidelity sends the money directly to your new IRA (actually, Fidelity sends you a check made out to the other institution and you pass it along. If the check is made out to you, it's an indirect rollover – see below). Effectively, the money simply changes names from a 401(a) plan to a rollover IRA.

cal.jpg As of Jan. 1, 2008, you have two options on how to do this: you can roll your money into a Roth IRA or a traditional IRA. If you roll into a Roth, you'll have to pay regular income tax on the pre-tax portion of the conversion (since you haven't paid any taxes on this DCP money yet) but it's worth it to get a Roth (see the reasons a Roth is better below). If you roll the money into a traditional IRA, you can then convert it to a Roth later. An important note here if you are married or leaving Berkeley for a high paying job: if your MAGI (roughly your total income minus pre-tax retirement contributions) on your income tax form for the year you roll over your money is more than $100,000, you cannot roll or convert the money into a Roth. In that case, you must roll the money into a traditional IRA and wait until 2010, when this income limit will disappear.

cal.jpg If you don't have another IRA to merge with your rollover IRA from DCP funds, you won't be able to put this rollover IRA money into an mutual fund unless you've saved over $1000 (you usually need $3000, but there are a few plans (such as Vanguard's STAR fund) which will let you start with only $1000.) In that case the money will have to sit in a low-yield account, such as a money market account, until you can supplement it with money from your pocket to get up to the minimum. Until then, it will still be tax-advantaged, but it won't grow very fast.

cal.jpg If you don't act to save your DCP money, Fidelity will mail it to you when you leave grad school (or after a sufficiently long period of account inactivity). By law, Fidelity will withhold a 20٪ tax penalty for early withdrawal of your retirement savings. If this happens, you still have a chance to save the money and avoid the penalty through an “indirect rollover”. To do this you must, within 60 days of the date on the check, open up a rollover IRA and put in the value of the check plus the 20٪ withholding penalty that was taken out. As long as you put the money back into a retirement account within 60 days, you won't be responsible for the 20٪ penalty (or, rather, you'll get it back when you do taxes because you'll add it to your “taxes paid” (listed on your 1099-R form) when calculating what you owe.)

cal.jpg Rollovers and conversions don't count toward your $5000 annual contribution limit; that limit only applies to new, out-of-pocket contributions.

The details of Roth IRA rules are kind of complicated. Here is an excellent website with clear and detailed explanations of the rules.

After Grad School: Other kinds of accounts

Many employers offer their own retirement plans, like 401(k)'s (if you're in the private sector) or 403(b)'s (if you're at a not-for-profit; these are also called “tax-deferred annuities”). These are a lot like traditional IRAs except funds come directly out of your paycheck. There are new Roth versions of 403(b)'s and 401(k)'s out there, too, which are pretty much what they sound like.

Sometimes an employer will kick in “matching funds” to a 401(k), up to a certain amount. If you ever get this opportunity, take it! It's free money. Invest $1, get another $1 from your employer and the taxes from Uncle Sam. Another way of thinking of this is that it's part of your rightful, hard-earned compensation. If your employer offers matching funds up to $2,000/yr and you don't take it, then you're leaving $2,000/yr on the table because you're not saving for retirement – shame on you twice!

If you have money saved that is in a regular, non-tax-advantaged way (savings, stocks, whatever) and you'd like to put it into an employer-sponsored tax-advantaged account like a 401(k), here's how to do it (grad students can't do this but postdocs can). Let's say you have $10,000 to convert, and your paycheck, after all automatic deductions, is $3500. For 3 months, elect to contribute an extra $3333 of your monthly income to your company's retirement plan. During those 3 months, “pay yourself” $3333 out of your $10,000 stash each month. After 3 months, your savings will have effectively been converted into your retirement plan. When you leave your job, you can then roll over your retirement plan into a rollover Roth IRA, as described above.


Beware of anyone trying to push a particular investment on you or your family (if you have elderly parents, they may be especially targeted by unscrupulous brokers). One kind of retirement account to be careful of is the annuity. If you hear this term, get suspicious. To be sure, many annuities, like a 403(b) offered by your employer, are fine, and if you're close to retirement and looking for guaranteed income that you won't outlive certain other kinds can be appropriate investment vehicles. Annuities get a bad rap because some are essentially commission-generating schemes whereby you are sold a complicated and inappropriate financial product (sometimes that you could have purchased yourself) and charged high fees for it. So don't let anyone pressure you or anyone you care about into buying an annuity or any other financial product – if you're unsure about any aspect of an investment run it by an independent financial adviser first.


cal.jpg An important note for those on fellowship or scholarship: the maximum allowable annual contribution to an IRA is the lesser of $5000 and your “compensation income” for that year, where “compensation income” is basically defined as the amount that appears on your W-2 when you file taxes. This means that if your only income is from fellowships, you can't contribute to an IRA, since that money isn't reported on your W-2. If your only “compensation income” is from summer research money, then you can contribute up to the amount you made that summer (or $5000, whichever is less). This page has more detailed information, though it doesn't mention fellowships explcitly.

Promised technical aside: Why a Roth is better

There are 3 main reasons to go with a Roth instead of a traditional IRA.

  1. Firstly, the maximum annual contribution allowed for all your IRAs combined is $5000. Since that's pre-tax dollars for the traditional and after-tax dollars for the Roth, the maximum is effectively 15٪ higher for the Roth. So the Roth is effectively up to 15٪ bigger, which really only matters if you're maximizing your contributions (but in that case it matters a LOT!).
  2. Secondly, you probably will be in a higher tax bracket when you retire than you are now, so the tax benefit will be greater then. This benefit is less important (and possibly negated) for people in a high tax bracket now.
  3. Finally, distributions from Roths are easier. For instance, unlike a traditional IRA, a Roth allows you to withdraw your principal (and for some expenses, like college, the gains) before you turn 59½ without penalty. Further, when you're 70½ you MUST make withdrawals from a traditional, whereas the Roth has no such requirement.