One of the biggest perks of being an adult is having a steady income. But how do you transition from scraping by during college to actually having a solid financial plan? Recent graduates are in the awkward period where you have enough money to start thinking about financial planning but not enough money to hire someone to do it for you.
With the new year starting, here’s an unofficial guide to how your excess money (which would be your revenue minus expenditures) should be prioritized.
Side note: Excess money should be defined as the amount of money you have left after paying down your high-interest credit card debt, student loan payments and any other debt obligations you may have.
Disclaimer: I am not a certified financial planner and all information presented below are from research.
Priority 1: Emergency Fund
Ideally, you should have enough accesible savings to sustain you for 3-6 months for any unexpected emergencies. An emergency can arise from a loss of a job, abnormal medical expenses, or any other curve balls life decides to throw at you.
To get an accurate amount of how large your emergency fund should be, follow these steps:
- Calculate your average monthly income.
- Calculate your average monthly savings.
- Subtrack the amount from Step 2 (your savings) from the amount from Step 1 (your income). This represents your average monthly expenses.
- Multiply the amount from Step 3 by 6 months.
It’s important to note that your emergency fund should be prioritized before your retirement investments because your retirement accounts can’t be easily accessed easily when needed.
Priority 2: Retirement Savings
Although it’s frequently said, I’m sure it’s worth repeating: it’s never too early to think about retirement, even in your early 20s. And theoretically, the earlier you start saving towards retirement, the less money you have to put in to your account (thanks to time value of money).
Here are some basic terminology for retirement accounts in layman’s terms:
- Traditional 401(k): This is a program sponsored by your employer where they deduct a portion of your paycheck (at a rate of your choosing) and the money grows in your account tax-free. However, you’ll have to pay taxes when you withdraw money from your account during your actual retirement. This is the most common type of retirement account provided by employers today.
- Traditional IRA: Works similarly to a traditional 401(k) – put money tax free now and be taxed later – but you set this up yourself rather than going through the employer. IRAs are best for those who are umemployed or employed by an employer that doesn’t offer 401(k) plans.
- Roth: Roth plans tax your contributions to the plan at the beginning but allow you to withdraw your money tax-free. Same as a traditional retirement plan, earnings in Roth accounts are not taxed. Roth can come in two forms: 401(k) plans or IRAs.
- Early Withdraw Penalty: There is a 10% tax penalty for withdrawing your money from your retirement accounts before reaching the age of 59.5. For traditional retirement accounts, this 10% penalty tax is in addition to the normal income tax you would have to pay upon the withdraw of money from your retirement account. There are exceptions to the penalty, but the circumstances are pretty extreme (e.g. large medical expenses).
- Matching Contributions: Some employers may match your 401(k) contributions up to a certain percentage. If your employer provides matching contributions, try to contribute to the percentage your employer matches up to. It’s essentially free money.
How do you choose the correct retirement account among so many options? Best rule of thumb is to go with the retirement plan provided by your employer, especially if they match your contributions (again, free money!). This should apply to 90% of you. If not, there are a lot of other factors to consider, so consult with the internet before opening an account.
Another important question: how much of your income should you contribute? The truth is, young professionals in their 20′s don’t know enough about what their lives will be like in their 60′s (e.g. life expectancy, standards of living, etc.) to make a determination. But here’s a helpful rule of thumb: you should ideally have a retirement account balance equal to 50% of your salary at the age of 30.
One more consideration: stocks or bonds? Stocks are riskier than bonds so you should invest more in equities (stocks) when you’re younger. But it all depends on your risk tolerance. Another rule of thumb: the percentage of investments in equities should be equal to 100% minus your age. For example, if you’re 23 years old, then you should have 77% of your 401(k) investments in stocks.
Priority 3: Everything Else
Congratulations! If you got your emergency funds and your retirement fund taken care of, you’re definitely one step ahead of the game. Now you can start thinking about potentially how to allocate the rest of your earnings. Although there’s a lot of different ways to invest your money, I picked the two that are most popular:
Real Estate (House/Condo)
The latest financial crisis devalued a lot of real estate property, which is encouraging a lot of people, including young professionals, to purchase a home. However, due to the same crisis and the number of foreclosures that occurred, lending rules have become a lot stricter. You’ll need a good credit history (above 750) and a down payment of 20% is recommended. That’s a considerable amount of cash, so start saving!
This is a loaded category since it comprises of stocks, bonds, commodities, options, funds and many other categories of financial instruments. If you have the time and knowledge to invest in stocks and commodities, kudos to you. But don’t start investing in areas where you don’t have enough knowledge in – it might do you more harm than good.
If you have limited knowledge about the markets but still want to invest, try looking at mutual funds or index funds. These funds require very little amount to start investing and can be purchased through online trading websites instead of relying on a broker. The funds can also span across different industries, types of securities and companies, which gives you a lot of options.
Having financial freedom is one of the best perks of being an adult, but making responsible financial decisions is the chore that comes with the perk. I use the word “chore” deliberately because it’s not optional – you will need to work on it eventually and it’ll definitely be less painful earlier than later. Good luck!