Congratulations, recent graduate: You just landed your first job and entered the real world. Now come tough questions about your financial well-being. Your decisions when starting out – from how to save to what to spend – influence your life far into the future.
Let’s begin with the end in mind, namely your best questions about retirement planning. How much money do you need to put into your company’s 401(k) plan? Always contribute as much as you can up to the company match (the latter is probably up to around 5% of your income).
Now ask yourself a few more questions. Does the plan offer a Roth component that will allow your contributions to grow tax-free? Do you expect your future tax rate to be higher or lower than your rate now?
With a Roth individual retirement account, you pay no income tax on plan contributions; your investment earnings – what your investments grow to – incur no income taxes, either. When you begin taking withdrawals from the plan, you again pay no income tax. If the plan doesn’t offer a Roth 401(k) contribution option, you may want to direct the dollars after the company match toward a Roth IRA.
When beginning to save for retirement, focus on details of your income: Make sure you save the correct percentage for your age, and make certain you build tax diversification into your accounts.
The proportion of your income you need to save to meet your retirement goals decreases the sooner you begin saving. If you’re younger than 25, for instance, you can save 5% to 7% of your income throughout your career and have a shot at fully continuing your standard of living at retirement age.
Tax diversification means that you want some savings exposed to taxes every year, some funds tax-deferred and, importantly, a bucket of money growing tax-free in a Roth instrument.
Paying for housing is another big financial determination. Rarely do young people stay in one place for long, yet the parental generation tends to endorse purchasing a home early in adult children’s careers.
Young adults also seem drawn to homeowning. A recent Zillow survey reveals that more than 80% of renters age 18 to 34 are “confident” or “somewhat confident” that they will eventually be able to afford buying a home. Slightly more than a third expect to buy a home within the next year; more than half expect to buy a home within the next five years.
The math shows that unless you expect to live in a place for seven years or longer, you are almost always better off renting. A home’s carrying cost – property taxes, upkeep, insurance and similar expenses – not to mention the sale price and related acquisition costs make owning property for a short time a crap shoot at best and a nightmare more often than you want to find out.
Finally, defending your credit score and knowing your debt-to-income ratio are mathematical metrics you must address.
Your credit score probably comes from Fair Isaac Corp., and takes into account such factors as your payment history, amounts you owe, the length of your credit history, any new credit and the type of credit you use. Your score falls between 300 and 850. Above 750 usually denotes excellent credit, around 650 fair and less than 600 poor credit.
Your credit score not only indicates your worthiness as a borrower but even affects such expenses as your car insurance rates. Don’t take that score lightly.
Your debt-to-income ratio – all of your contractually obligated monthly expenditures divided by your income – looms large with lenders consider when you apply for a mortgage. Ideally you want this debt to constitute about 37% of your monthly income.
One of the best bits of encapsulated advice for young adults, and for everyone else? Manage debt or it will manage you.
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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He is the host of Consider This with Big Joe Clark, found on WQME and iTunes. Big Joe can be reached at email@example.com, or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.
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