This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.
With freedom comes responsibility. The duality of freedom and responsibility exists throughout our lives. For many of us, this starts to become apparent in our early adult years, at which point we’re given the freedom to decide how to allocate our time and money along with the responsibility of paying our own way, which isn’t cheap.
Though many of our clients desire to remove the burdens of debt for their lineage, they also realize the best habits are often built early. Unfortunately, a subject such as “Finance 101 for Young Adults” isn’t typically part of the school curriculum. As a result, our clients often turn to us with questions about setting up their children for success without hindering their ability to be independent.
So, as the season approaches to send your kids off to college or into the workforce, we thought we’d share a few guidelines to build the foundations of a healthy financial future.
Where to Begin
As a young adult, sometimes the most challenging part of the journey is simply knowing where to start. Maybe it’s the first time you’ve had extra cash in your wallet, and you’ve never had the luxury of deciding where that should go. Maybe you have student loan debt; maybe you don’t. Here are some practical places to start stockpiling in order of priority:
1: Build up a “rainy day” fund.
Unexpected expenses pop up for everyone. Whether it’s as minor as a flat tire or as major as a hospital visit, it’s important to plan for the unexpected. Otherwise, you’ll be forced to take on debt at high interest rates to cover an expense that wasn’t optional.
For a single individual, save a minimum of six months’ worth of fixed expenses. For couples with dual incomes, a minimum of three months’ surplus is advisable.
Leave these funds LIQUID. This means cash or high yield savings¹ that can be easily accessed without risk of losses from market fluctuation.
For most college students, this is the first time you’re required to budget on your own. Be mindful of your spending habits, and put away the excess into your rainy day fund. Even if the amounts are small, you’ll be surprised at how much deposits add up over time! Just think, $1 per day over three years would be over $1,000.
2: Secure the free match.
Would you ever turn down free money? If you’re not taking advantage of an employer match, that’s exactly what you’re doing! Companies with qualified employer plans (e.g., 401[k]s) generally offer an incentive match. This means if you contribute money to your future, they will, too.
Typically, you contribute a percentage of your salary to a plan. The match is a percentage of whatever percentage you contribute, up to some percentage cap. For example, if your employer contributes 50% up to 3%, that means that for every dollar you contribute, up to 3% of your total salary, your employer will deposit an additional $0.50. So, if you make $50,000 per year and contribute $1,500 per year, your employer will contribute $750.
3: Tackle debt.
Debt compounds against you as interest payments accrue. If you don’t pay down the principal (original loan amount), the balance of what you owe keeps growing.
Not all debt is bad debt. For instance, many people borrow for education. It’s an investment in your future at a time when you may not have the income to afford it. By making regular, timely payments after school, you can build up your credit score in the process of paying down debt. On the other hand, many other forms of debt, such as credit cards, have high interest rates attached to borrowing. If you’re not careful to pay these off monthly, the debt can snowball and damage your credit history.
Generally, the best course of action when deciding between paying off debt and investing is to compare your annual after-tax interest rate against your projected after-tax rate of return on investments. If your debt interest rate is lower than your expected rate of return from investing, you should consider investing. If the opposite is true, you might focus on paying off your debt first.
4: Contribute to a Roth IRA.
If you have earned income according to IRS standards, you can open and fund a Roth IRA, subject to income and contribution limits². This means even a teenager with a part-time job can establish and fund a Roth IRA. Since you contribute after-tax dollars, you’ll never be taxed again on the contributions or growth as long as you follow withdrawal rules.
While Roth IRAs are geared for retirement, they offer more flexibility than many other retirement savings vehicles. You can withdraw your contributions penalty-free at any time for any reason. This means that you can save for the future and still tap into the contributions if the need arises. Plus, some earnings can be withdrawn early penalty-free in specific situations, such as for the purchase of your first home.
5: Contribute more to your employer plan.
If you’ve paid your bills, allocated money to items 1-to-4, and still have income to spare, you can always contribute more to your company’s retirement plan. While you won’t receive a match on additional dollars, you will still receive tax deductions for pre-tax contributions and put your money to work in the markets.
Balancing Lifestyle with Long-Term Goals
Striking the right balance between saving for your future and affording life today is no easy task. Below are a few target percentages and considerations to help you stay on track.
The general rule of thumb is to save 20% of your income each paycheck for the future — the rainy day fund, retirement savings, and college tuition we discussed above fall into this category. Financial advisors will dial in savings rates to specifically fit your situation, but this is a great starting point for those just beginning their financial journey. It can seem daunting, but it’s made much easier if you set up automatic deposits. Employer plans typically allow for automatic payroll deductions, and you can set up recurring contributions from your checking accounts to fund Roth IRAs and high-yield savings accounts among others. By automating good habits in this way, you’ll bolster your savings before you have the opportunity to spend your extra cash, preventing lifestyle creep.
For voluntary obligations, also known as your “wants,” do you actually need it? If not, how much value does it give you? Maybe you can give up that $6 oat milk latte each day, giving you $2,190 at the end of the year. That will buy you a vacation and leave you with additional savings.
For fixed expenses, an easy way to assess whether you’re living within your means is the 28/36 rule. The rule suggests that you spend no more than:
- 28% of your paycheck before taxes on rental or mortgage expenses.
- 36% of your paycheck before taxes on all debt services, including home, auto loans, student loans, credit cards, etc.
Of course, your ability to stick to these percentages will be dictated in part by where you live and work. For example, if you live in metropolitan California, you’ll probably have trouble finding housing less than 28% of an entry-level job salary. In that case, maybe you cut back more elsewhere in your budget knowing that your rental expense is higher than ideal.
Planning for your future is already overwhelming. Planning for a financially stable future can be downright complex. That said, financial literacy and being budget savvy can start with a few small steps that will have you thanking your future self.
1 High yield savings accounts offer the same safety of principal as traditional savings accounts at significantly higher interest rates (typically 20-25x national average). Banks are typically not brick and mortar, but they are FDIC-insured and allow for easy electronic transfers in as well as withdrawals up to 6x monthly.
² Check out IRS Publication 590-A to see if you qualify to contribute to a Roth IRA.