9 Financial Tips for Young Adults
Who came along and helped you get your finances in order? Was it a parent, friend, or significant other? No matter who it was, we could all benefit from additional instruction on how to better manage our finances. If you are a young adult looking for direction, then this is the blog for you as I will cover nine tips that you can employ to improve your future finances.
Key Takeaways:
· Why it’s Important to Create a Budget
· Building an Emergency Fund
· Invest in your 401(k) Plan
· Pay Off Your Credit Card Debt
· Take Care of Student Loans and Start Savings!
· Contribute to your Retirement Savings or Investment Account
· Tackle Any Other Debt You May Have
· Make Sure You Have the Proper Insurance Coverage
· Create an Estate Plan
Why it’s Important to Create a Budget
The first tip for any young adult is to create a budget. I recommend this to everyone, but I see a few additional benefits that young adults can take away from it. The first step to creating a budget is to determine how much income you are taking in. This could either be on a weekly, bi-weekly, or monthly time frame, whichever you think makes the most sense for you. Personally, I would suggest doing this on a monthly time frame.
The next step is to determine your expenses. A lot of this information can be found on your past credit card and debit card statements. Certain expenses will be the same amount each month (fixed) like a Netflix subscription or rent while others will vary per month (variable) like dining-out. For these variable expenses, I would suggest taking the average per-month average over the past twelve months as a start. If said expense increases in the following year, then you can always go back and adjust the numbers to improve accuracy.
You should then separate the expenses out between essential and discretionary expenses. The essential expenses include rent, insurance premiums, and other things that you cannot live without. While discretionary expenses are those extra things that you like to buy/do but are not required. This could include dining-out, vacations, subscriptions, and other types of entertainment. If you find that your expenses are too high, then the first spot to start cutting would be under the discretionary section.
The next step would be to figure out what is left at the end of the month. For this you would simply subtract your total monthly expenses from your total monthly income. If you are left with a positive amount, then you have monthly savings that can be allocated. To contrast, if the value is negative, then you are currently running a monthly deficit which will require further action. This could include either cutting costs or finding ways to make additional income.
There are plenty of resources online to help you create your budget. I would recommend using excel, you can either create the template yourself or download one for free online. You can follow the link to the free budget worksheet I provide to clients. Additionally, I will link an article from Nerd Wallet of different apps that you can use to help track your budget.
Building an Emergency Fund
The second tip is to build an emergency fund. It is important to have an emergency fund composed of a few months of income to provide for yourself just in case you lose your job or run into any significant unexpected expenses. For example, when Covid struck a lot of people we were underprepared. The virus caused many individuals to lose their jobs as the government implemented procedures to enforce isolation to end the spread of the virus. These laws caused businesses to pause operations and subsequently led to a lot of layoffs.
I suggest that young adults start with a few thousand dollars. If you can start building the emergency fund early, then it will be easier to save up a sufficient amount for when you need it. After a year or two of working and collecting paychecks, I would suggest that you have 3-6 months’ worth of expenses saved in the emergency fund.
Many people use their credit card as an emergency fund. They use the credit card to cover all the expenses they cannot afford and stack up a large amount of debt which they plan to pay off when they can. The issue with this strategy is the high rates of interest that credit card companies charge on debt. Currently, the average credit card interest rate in America is 23.55%. Granted, this is an annualized rate so you would accrue 1.96% of income each month.
Therefore, I would suggest holding your emergency fund in a highly liquid account. Two great options in a savings account or brokerage account where you can invest in a money market fund. A savings account is a good option because there is no risk of losing your money and you will receive some interest on the money.
To contrast, a money market fund pays substantially more interest, but requires that you open a brokerage account. This one issue with this method is the delay between when you sell the fund and when you receive the money. There is a two day settlement period before you can withdraw funds after selling a mutual fund, and it takes a few more days for the money to arrive in your bank account.
Invest in Your 401(k) Plan
The third tip for young adults is to contribute to your company’s 401(k) plan. The rule of thumb is to invest at least the percentage that your employer is willing to match. Let’s say your employer offers a 4% match to 401(k) contributions. If you contribute 2% then your employer will contribute 2%, and if you contribute 6% then your employer will contribute 4% as that is the maximum percentage that they are willing to match.
If your company doesn’t offer a 401(k) then you need to make sure that you are still saving money. There are several ways to do this, one would be through an Individual Retirement Account (IRA) that you can set up. I would suggest you create an account with one of the established custodians such as Charles Schwab, Vanguard, or Fidelity. The account should be free to set up because most companies allow individuals to set up accounts without cost.
The 2023 IRA contribution limit is $6,500 for individuals under the age of 50. There is an additional $1,000 catch-up clause for individuals aged 50 and older for a total contribution of $7,500. Now, the 401(k) contribution limit in 2023 is $22,500 and $27,000 for individuals age 50 and older. Therefore, you can save a lot more money through a 401(k) than an IRA each year. For this reason, if your company offers a 401(k), but no employer match, then I have a strategy that you can use.
It is not common, but there are plenty of companies that offer a 401(k) without an employer match. For these individuals, I would suggest that they contribute to an IRA instead of the company 401(k). As mentioned, employer 401(k)s often have a lot of limitations and are therefore not the best place to save money. The individual should start to contribute to their company 401(k) once they have maxed out their IRA contribution for the year. This way he/she can save more than the $6,500 limit and a significant amount of it will be with little to no limitations.
There are a few common limitations associated with employer 401(k)s. The first is a limit on the number of reallocations that can be made each year. The other limitation is the available investment options within the plan. Unfortunately, there are a lot of companies that do not provide enough investment options to create a diversified portfolio. They fail to include international, real estate, or even small cap index funds. In addition, they include investment options that are expensive to hold which you can see through the fund’s expense ratio. I typically invest in low cost funds that have 0.03%-0.06% expense ratios, compared to many employer 401(k) investment options that have expense ratios of over 1%.
Pay Off Your Credit Card Debt
Tip number four for young adults is to pay off any accrued credit card debt. Everyone should avoid carrying credit card debt, not just young adults. However, it’s important for young adults to learn now before they make decisions that could set them back in the future. Credit card debt is tricky, if you accumulate enough then it will become difficult to pay off the principle amount. If you are in this situation, then I would recommend employing one of the strategies explained below.
There are a few key methods that individuals use to pay off their existing debts. The first strategy is called the debt avalanche where you begin payments on your debt with the highest interest rate. While making these payments, the individual will have to cover the minimum payments on their other debts to avoid any additional fees. Once they finish paying off their highest interest rate debt, the individual will move on to their second highest interest rate debt, and so on. This method would be ideal for those who are motivated to start paying off their debts.
To contrast, the other strategy is called the debt snowball where you begin payments on your debt with the smallest balance. Like the method above, the individual will have to pay the minimum payment on their other debt to avoid any additional fees. This strategy is suitable for people who have struggled to pay off their debts. There could be many causes of this including a mental block or the reluctance to make payments now that the balance has grown so large. The reason I would suggest the debt snowball to these individuals is because there is a certain feeling of accomplishment when you pay off a debt. By starting with the smallest balance, the hope is that the individual will ride the feeling they got from paying off the first debt and continue to pay off their debts one at a time.
The other option is to consolidate all of your debts into a single loan. There are different strategies that you can use here, but the bottom line is that you want to get the debt eliminated as quickly as possible. Once the debt is paid off, a lot of people recommend hiding the cards for a few months to avoid falling back into the same trap. Others recommend cutting the card up for a sense of closure, but there’s one issue with that. Technically, you could cut up the card, but I would not recommend closing the account itself. You should not close your oldest line of credit as the longer it’s open, the better the impact on your credit score.
Take Care of Student Loans and Start Saving!
The fifth tip for young adults is to pay off any private student loans. Student loans can be classified into two categories. They can either be federally subsidized or private. There are several differences between the two, but private debt is usually held at a much higher interest rate. Regardless, you are going to want to pay this debt off as quickly as possible.
I suggest looking for available federal programs to pay off your debt faster. An example would be the Public Service Loan Forgiveness (PSLF) which is provided by certain employers such as Federal, State, and Local government. Under this program, those who have made 120 qualifying monthly payments while working full-time for a specific employer will have the remainder of their student loans erased. Therefore, if you are eligible for one of these programs then I’d highly recommend applying.
Contribute Towards Your Retirement Savings or Investment Account
The sixth tip for young adults is to contribute towards a retirement savings or investment account. This would make sense for people that have leftover cash after they have covered their essential and discretionary expenses. A great place to invest these funds would be within a Roth IRA, or Traditional IRA as a secondary option. A Roth IRA would be a suitable investment account because the contributions are post-tax. In addition, the underlying investments grow tax deferred and can be withdrawn tax-free in the future.
Individuals in their 20’s and 30’s should target a savings rate of at least 10%. For example, an individual in their 20’s should have/or be in the process of getting a full-time job. A lot of these individuals will proceed to live at home or work remotely so their total expenses should be limited. These individuals should save at the very least 10% per month as they likely have the capacity for more. To contrast, an individual in their 30’s could have children and a mortgage. Saving 10% per month may not be possible for these individuals so I would recommend saving as much as possible when you are younger.
Meanwhile, an individual in their 40’s and 50’s should be established in their career and have few moving parts in their everyday life. The ages 40-50 are prime saving years as the individual gets a better sense of how much everyday life costs, and how much they need to save to continue living said lifestyle. For these individuals, I would recommend a savings rate of 15%.
Another way to save money could be through a brokerage account. The benefit to a brokerage account is that your money is more accessible. Retirement accounts require individuals to be age 59 and a half or meet a certain criteria until funds can be withdrawn without penalty. Therefore, if you want to save additional funds but fear needing the money later, then a brokerage account may be more suitable for you.
Tackle Any Other Debt You Might Have
The seventh tip for young adults is to tackle any other debt you may have. This could include any lower interest rate debt such as a mortgage. A lot of people choose to keep low interest debt (no extra payments) if the interest rate is below 4% because they assume the money will grow at a higher rate than the interest. If you could invest your idle money and make 8% per year, then why would you pay extra money towards a debt with 3% interest? Through investing the money, you would have an additional 5% that you could leave invested and receive the benefits from compound interest.
Make Sure You Have the Proper Health Insurance
The eighth tip for young adults is to make sure you have the correct insurance in place. This includes both life insurance and disability insurance. Life insurance is more important for those with a spouse and/or family. It protects them in the case of your untimely death as the insurance amount is paid out to your beneficiary which should be used to replace the loss of income. Disability on the other hand, protects the individual if he/she is no longer able to work. The disability insurance provides a fixed monthly payment to the injured for the amount chosen at issuance which is typically in line with the income that he/she has lost.
If you work for a company that offers group benefits such as a group disability plan, then I would recommend enrolling in the plan. They are relatively inexpensive and would cover you in the event that something happens and you can no longer work. These plans usually cover you until age 65 so it will cover you throughout your working years.
If your company does not offer any type of disability coverage (short term or long term) then you should go out and purchase your own. Make sure you find an independent agent who is not biased towards any company’s products. You want to find someone that will find you the most cost-effective plan that covers everything you need.
The other form of insurance a young adult should consider is term life insurance. It could be a good idea to purchase a term policy while you are young and healthy because the premiums required will be lower. This could make sense for young adults that have a lot of health issues in their family or do a lot of high risk activities such as sky diving.
Create an Estate Plan
The ninth and final tip for young adults is to have an estate plan set up for yourself. I would imagine that most young adults are healthy and not yet thinking about their potential death. However, there are two things that are inevitable in this life, and that is death and taxes. Therefore, you should be responsible and create at least a basic estate plan while you are a young adult. This way, your family will not be left with a non-organized estate that could cause a lot of additional stress on your loved ones.
There are a few easy things that you can do. First, is to ensure that a beneficiary is listed on all of your retirement accounts. If you don’t have any children or a spouse, then I would suggest listing a parent or trusted guardian. You should also list a contingent beneficiary which could simply be your other parent or guardian.
The next thing you should do is ensure that all investment accounts and bank accounts are set up as transfer on death or payable on death accounts. These accounts make the process simple as they automatically transfer to your beneficiary listed when you pass away. The beneficiary can be anyone of your choice, but you would likely use the same people you listed as beneficiaries for your retirement accounts.
The last, and likely the most important step is to draft your will. You can do this online through sites such as legalzoom.com. When speaking with the lawyer, make sure to designate both your financial durable power of attorney and healthcare power of attorney. The financial durable power of attorney is given power over your financial decisions if you are incapacitated or dead. While the healthcare power of attorney does the same, but for health related decisions. If you can complete these few steps, then your estate will be in a good place moving forward. Just make sure to review the documents every few years to update them for any changes.
If you are interested in learning more about what you can do to improve your finances in the future then I would recommend listening to my weekly podcast, Retire with Ryan. Additionally, if you are looking for specific recommendations then you can schedule your Free Retirement Assessment on my website, Morrissey Wealth Management.
