When starting your first job (of your professional life, not the lifeguard gig you had in high school) your sudden increase in income, although exciting, can also be quite misleading. With the start of your career comes a whole new set of both near- and long-term obligations, as well as opportunities to financially thrive in the future. It’s easy for someone in their 20’s to not worry about making long-term financial game plans, but by failing to do so they are setting themselves up to be in a worse position later in life and bypassing important steps needed to mitigate unforeseen life risks that could happen at any time.
The first thing that is essential for anyone starting their career to do, possibly before even receiving their first paycheck, is to create a budget. You’ve probably made some budgets in the past (and likely stopped following them quickly). But it’s important to understand this isn’t your allowance budget anymore, you’ve entered the big leagues and the risks of mismanaging your spending have become exponentially higher. Creating a budget gives you a plan to follow and stay within your means while giving you a better sense of how much money you’re allocating to things that frankly aren’t very important or necessary to you.
A commonly used budgeting technique is the 50/30/20 rule. The rule is straightforward and simple to follow, suggesting that you divide up your after-tax dollars and allocate 50% on needs, 30% on wants, and 20% on savings. Your needs constitute the bills you must pay and things necessary for survival (rent, car payment, groceries, insurance, etc.). Your wants consist of all the other things you spend your money on that aren’t essential (dinner/nights out, vacations, gym memberships, etc.). When determining what’s a want or need, be 100% honest with yourself because at the end of the day you are the biggest victim to your own irresponsible spending. The last 20% is savings which you would stow away in an emergency fund, IRA contributions, investing, etc. If you haven’t started receiving your paycheck yet you can use one of many paycheck calculators to estimate your after-tax income, such as Smart Asset. Of course, circumstances vary, and the 50/30/20 rule is a good baseline but may not work for everyone. As those like myself who live in Southern California know all too well, 50% for needs may not cut it with today’s rent and gas prices. In that case, you will need to adjust your budget accordingly and try your best to leave the 20% dedicated to savings untouched.
Consider your savings as a way of paying yourself and when it comes to your income, you should always pay yourself first. No matter how young you are, putting money towards an emergency fund is one of the best decisions you can make. A commonly advised rule is to build to and maintain at least six months’ worth of living expenses. This of course seems like a daunting task when you’re first starting off but even a small monthly allocation into this fund will build to a sizeable savings over several years. In dictating the amount you put towards an emergency fund, take an honest look at your job security and debt situation. Those who have a stable job and high-interest rate on their debt should probably put most of their savings towards paying off the debt, but for someone in a low-interest rate situation, then the emergency fund might take precedence. If you’re in a volatile industry that has a low average level of job security, then it’s especially important that you save an adequate amount of funds that you can easily access given you go unemployed for several months. Even if you can honestly assess that you have a high level of job security, you should continue adding funds just in case. No career or industry is 100% bulletproof. Not to mention unforeseeable life events can arise that cause unexpected expenses like medical bills. Sure, it might seem ominous or unnecessary for someone young and perfectly healthy to be preparing themself for a serious medical condition, but unforeseeable events happen to people all the time and in the case that it does, you will be much worse off if you hadn’t financially prepared yourself beforehand.
Even though retirement may feel like a lifetime away, the decisions you make in your 20s can have a serious impact on your retirement situation many years down the line. Investing your savings account from an early age can make a huge difference on the principal of that account 40 to 50 years down the line. Over the U.S. stock market's history, there has been a tremendous track record of growth. Even just a small amount saved and invested in your early 20s can produce great returns for you down the line. So, while there’s a small opportunity cost in the short-term by saving now for retirement, you are losing out on a much bigger opportunity cost in the long run when you choose not to begin saving money now.
Many employers offer company-sponsored retirement plans and will match a certain amount of your contribution. If you work for one of these employers, then you have a great opportunity and should take advantage of the matched contributions as much as you can within the bounds of your appropriate budget. It’s important that you educate yourself on your different retirement plan options and possible investments to ensure your money is being handled wisely.
401k Plan – The priority would be to contribute enough to take advantage of the employer match. This can be as much as 3-6% per year. Next, if your company offers both a traditional pre-tax 401k and a Roth 401k, determine from a tax perspective which is the better option for you personally. Generally, if you are younger and in a lower tax bracket, the Roth 401k is the best long-term option.
Roth IRA - One of the only tax-free investments today. Contributions to the Roth IRA are made with after-tax dollars meaning that your assets appreciate and are withdrawn tax-free, given they are withdrawn at the appropriate time. A 25-year-old maximizing their contribution every year until the age of 72, would realize an estimated $600,000 in additional savings by utilizing a Roth IRA in comparison to a Traditional IRA. You can read my previous article on Roth IRAs for more information.
Given that a 401(k) isn’t the most flexible plan as far as investment options are concerned, it could be that the optimal course of action would be to invest in multiple accounts, perhaps maxing your company’s contribution limit in a 401(k) and investing the rest of your savings into a traditional or Roth IRA. Everyone’s situation is different, it is important that you take the time to research the various options you have for retirement saving or consult with a fee-only financial planner.
Your employer may offer insurance benefits as well and it’s important that you consider the various risks and financial factors that come with each. Your employer may offer life insurance with a death benefit of up to three times your annual salary. Given that life insurance is typically one of the cheaper benefits offered, this could be an attractive option. However, the downside is that if you leave the company then you probably won’t be able to take your policy with you. Given employee turnover is incredibly high across the country, this policy likely wouldn’t make sense for someone in their 20s. But it might be a good idea to purchase your own life insurance while you are young and healthy, and the policy will therefore be less expensive than if you wait. Even if you don’t yet have a spouse or kids, having a baseline of coverage could be a wise decision for when you do end up with dependents.
Disability insurance is another possibly wise benefit to receive. Disability insurance is used to protect a portion of your income if you become too sick or injured to work. If you’re a healthy individual, the odds of this happening to you seem incredibly unlikely. While most employees won’t need this in their lifetime, a shocking 25% of 20-year-olds will become disabled before they reach retirement age1. Much like life insurance, disability insurance is less expensive if you purchase it while you’re young and healthy. So even though you may not yet foresee a need for it, it could still be a smart decision to make the investment while you’re young. Disability insurance through employers typically only lasts until you leave the company though, so you may want to find a private insurer if you’re in this situation.
Much like disability insurance, health insurance may seem like an unnecessary expense but becomes the best decision you’ve ever made if you don’t end up needing it. For those under 26, your best option is likely just to remain on your parents’ health insurance plan, which also gives you time to prepare to purchase your own. When the time comes to have your own health insurance policy, you can turn to your employer or find federal and state plans offered by Health Insurance Marketplace of the Affordable Care Act.
When we’re young and healthy, most of us fail to give proper consideration to the unfortunate factors of life that can change our financial situation in an instant. Not to mention, there is incredible growth potential to be had by investing while you’re young. A Redwood planted in even the most ideal conditions, won’t grow anywhere near to as tall as one given several decades to mature. Picture your savings accounts in the same way. Give your savings a long period of time to prosper while “nourishing it properly” and 40 years later, you’re likely looking at a colossal-sized account. A Redwood seed starts as only about the size of a tomato seed. Similarly, even by making small contributions, an investment account can blossom given enough time and the proper decision-making.