Your standard of living helps dictate your entire financial world, and how realistic your medium and long term financial goals are to obtain. The time value of money is on your side, and it is critical that you take advantage of this. Coming from a college student budget, or an entry level position, you have a prime opportunity to write out your goals and start saving dollars on a monthly basis. A general rule of thumb is to attempt to save 20% of your gross income. This ability to save 20% needs be a habit started from the very beginning of your career, prior to a larger portion of your take home income being consumed by family or other aspects of your life. It is much easier to start saving from the beginning than to wait many years. Even if you expect your income will gradually increase throughout your lifetime, there are many factors that will make you wish you saved earlier, like additional fixed expenses, higher cost of living, children, and the unexpected. These life developments quickly eat away at salary raises, and saving more becomes even more difficult. Whether it’s a mortgage payment, car payment, children/childcare, new expenses come into the equation and it’s difficult to ever save what you were once doing early in your career. You may want to consider starting with a less expensive home, allowing you to still allocate significant dollars to your investment accounts early in your career instead of taking on a large, illiquid asset as your primary residence. As the family develops in your 30s upgrade your primary residence. Some use this transition to sell and liquidate their first house, while others keep the original place as a long term rental property. A starter home could eventually be a cash flow positive rental property. What is your strategy?
Millennials will experience an unprecedented number of career changes and volatility in the job market. That is why it is so important to build a 4-6 month emergency reserve in your bank account. You can calculate this by creating a simple budget and determining your monthly fixed expenses. You need this cash reserve in case the unexpected happens, whether it is your job, health, house, car or family. The best part is it will be sitting in a safe FDIC-insured bank account, protecting principal, so you don’t have to jump into your investment accounts at the wrong time. The markets have consistent short term volatility, so you don’t want to liquidate holdings if you need them unexpectedly. But balance is important – you do not want to be overweight on your checking or savings accounts, which earn very little return. According to US government (Dec 11th, 2019), inflation in the US averaged 2.1% over the last 12 months, and averages 3.22% in US History. Because of this, we have to be cognizant that we eventually may be keeping too much money in this safe low interest bank account, and should instead be moved into medium to long term investments accounts where the equity exposure will help defend against inflation.
Debt these days is virtually inevitable, and it’s important that you understand the difference between good debt and bad debt to best leverage your overall financial situation. Early on, our first true test is how well you can manage your credit card spending. With such high interest rates on credit cards, your goal should be to never carry a balance from month to month, and instead only charge onto your credit card what you plan to pay off that month. Your credit score is affected by carrying a balance, which is why it’s recommended to never be using more than 30% of your overall credit limit. A credit card is best used for day to day expenses instead of a bank debit card, as it helps build your credit, but also provides you points/perks for every dollar that you spend. These points allow for potentially free travel that all millennials are so eager to do. Depending on your credit situation, it might make sense to change up your credit card every couple of years and reap the new card rewards. Building up your credit score to a 640 or better in your 20s is important so you can eventually qualify for a home mortgage. Your credit cards along with your various other monthly bills need to be paid off monthly to continue to build your score. A good credit score will earn you a better interest rate when you buy your first property.
The student loan epidemic in the US is at an unprecedented all-time high, and unfortunately students are often under-educated on how to efficiently build their net worth while properly managing a six-figure school loan. A general rule of thumb is to separate good debt and bad debt by a 7% threshold. High interest debts such as credit cards and personal loans need to be paid off right away, but debts in the 3-6% range may need to be managed differently. Why? These types of low interest debts may be better off maintained, while your savable dollars have the opportunity to earn in the market through various investment vehicles, giving the opportunity to potentially earn a higher rate of return than paying off all the debt. It is so important to take a holistic view of the financial picture, and establish an efficient cash flow strategy so you have the best chance of reaching those long term goals. How you structure your monthly allocations in the first decade of your career is very important step to your overall success.
A common oversight within a millennial’s financial portfolio is the lack of medium term investments, meaning investments that can be easily accessed prior to age 59 ½ years old. Employers typically provide some guidance and opportunities with long term retirement vehicles such as, 401ks, 403bs, 457s, TSPs, DCP plans, etc. Yet, it’s typically up you to establish an outside nonretirement investment account for additional accessible savings prior to retirement. When I do see non-retirement investment opportunities though is when a company provides stock options to its employees, which could be provided at a 3-15% discount and a required minimum holding period. It is often a great idea to start utilizing this stock purchase plan, but many investors don’t think to diversify away from their own company stock once it’s able to be liquidated. They end up with a large part of their net worth invested in one particular company, which is risky. Plus, if the company starts to perform poorly and as a result, has to lay off a portion of its workforce, the poor investment diversification decision is magnified for you personally. I’ve also found an optimistic bias in this situation because the stock holding is part of the company that they work for, where someone might consistently “drink the Kool-Aid” and believe in the hopeful growth of the company more than they should. With that said, it’s important to establish this nonretirement account, but important to manage the risk. While diversification does not guarantee against loss, it does help spread the risk and manage volatility in your investment portfolio.
It’s never fun saving money when you are young, especially if you can’t touch it until you're practically in retirement. But as the old adage goes, “the early bird gets the worm.” Nothing is truer when it comes to investing. This is because the power of time value of money and the potential compounding interest effect has decades to build and multiply your net worth. Early on, small investment accounts don’t grow too much more than the contributions consistently being put in every month. Yet as years continue, dollars within your accounts will start to compound and begin working for you. An additional ten years of growth in the beginning of your career has the potential to drastically impact the amount you will eventually be able to liquidate from your account. This may be the most important piece of advice when it comes to investing.
In addition to investing early, you should also think about whether you are contributing to pre-tax or after tax retirement accounts, as each account has its pros and cons. The main example of after-tax retirement account is the Roth IRA, typically set up outside of your employer. A maximum of $6,000 can go into the account after tax on an annual basis, but then any growth and distribution of that Roth account will come out 100% tax free at 59 ½ years or older. For a Roth IRA, earnings withdrawn prior to reaching age 59½ and/or not meeting the five-year holding period may be subject to a 10-percent penalty in addition to income tax. This is different from pretax accounts, like the 401k, into which contributions go pretax (a dollar for dollar decrease off your taxable income during that contribution year). Those dollars continue to grow and will eventually come out as taxable income when you take distributions during retirement. The 401k helps you more today, while the Roth IRA will help you more tomorrow.
So which is best? Well, an investors' anticipated tax bracket in retirement will determine whether a Roth account or a traditional retirement account will provide more money in retirement. Generally, investors who expect to be in a higher tax bracket at retirement relative to their current tax bracket, will benefit more from a Roth account.
A question to ask yourself is, “do you plan to have a higher standard of living during retirement or during your 20s?” If your answer, like many, is you plan to have a higher standard of living in retirement, then the Roth IRA might be more advantageous than a pretax qualified accounts. Although it can’t be confirmed, many experts also believe that income tax brackets for the average American will be higher in the future because of the government’s increasing debt situation . Now take a moment to think of your own career trajectory, and consider your current and future tax brackets. Retirement is difficult to navigate and recommend you consult with a qualified financial advisor.
While the offensive topics above are important, it’s the defense that wins championships. For a millennials, long term disability insurance is an important type of coverage you should seriously consider, as your ability to make an income is by far one of your greatest long term assets. This type of coverage would replace your income if you are unable to work because of an accident or illness. You’ll normally receive 50%-60% of salary covered through a group benefits plan from a large employer, and then private coverage is needed in addition to it to supplement the lack of total coverage from employer benefits. The Social Security Administration estimates that one in four 20-year-olds will become disabled and unable to work before they reach the age of 67. As you age, you will have more and more responsibilities in addition to your student loan and home mortgage payments, which is why it’s so important that you outsource this risk to an insurance company. Ask yourself this, would you rather insure the golden egg or the goose that laid the golden egg? Precisely my point!
Life insurance is also an important selfless purchase one might consider making during your 20s when you are healthy and young enough to obtain inexpensive underwriting rates. Term life insurance is typically recommended when you have a child or soon to have a child, buy a house with a spouse, when your parents are cosigners on your private student loans, or when your parents are depending on you during their retirement years. It could also be used to leave a legacy to a foundation or a charity of your choosing if you don’t have dependents at the moment. There are numerous types of life insurance, and is important that you sit down with a professional to decide on the correct coverage for your unique situation.
Written by Zachary MacDougall, Financial Advisor - CA# 0H70687
This information is a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender periods. Financial Advisors do not provide specific tax/legal advice and this information should not be considered as such. You should always consult your tax/legal advisor regarding your own specific tax/legal situation