What every new college graduate should know about wealth planning
May 22, 2018
John Maddison, CFA, CFP®
Relationship Manager, Balentine
While cleaning out an old filing cabinet in my attic, I recently discovered the very first paycheck I earned after graduating from college. Memories from that time came flooding back, along with the realization that I—like so many other new college grads—had been incredibly naïve when it came to budgeting and saving. It pains me now to admit that even though my two roommates and I were crammed into a small two-bedroom apartment, my monthly rent was a whopping 60% of my take-home pay—I guess that’s New York City for you! Obviously, this left little for spending, let alone saving. Thankfully, I became adept at cooking rice and beans, allowing me to have enough money for the weekends. But looking at that 17-year-old paycheck, I wondered how I might have approached my first “real world” earnings differently if I’d been as knowledgeable then about finances as I am today.
As a CERTIFIED FINANCIAL PLANNER®, family, friends, and clients often ask me for advice about financial wellbeing that they can share with their children. There’s always an uptick in these requests each May, coinciding with college graduation. Though I can’t go back and tell my 22-year-old self not to blow more than half my monthly income on rent, I love that my job allows me to help today’s graduates make better financial decisions than I did at their age. To the class of 2018, here are my recommendations for approaching your first “real world” earnings:
- Maximize your employer’s 401(k) match. Many employers match employees’ 401(k) plan contributions, and some even provide an automatic contribution, called a safe harbor, regardless of whether the employee contributes. Maximizing your company’s match is the closest you’ll get to a “free lunch” in your retirement savings. With a $50,000 starting salary, a 3% match equates to a $1,500 annual “bonus” from your employer. Additionally, many plans allow employees to proactively increase their contributions annually. What does this mean? While I may, for example, contribute 7% to my 401(k) in 2018, when I initially established the plan I might have set my contribution to increase 2% per year until it reaches 15%. We can thank Nobel Laureate Richard Thaler and Schlomo Bernartzi for championing “Save More Tomorrow,” a behavioral intervention designed to boost how much American workers save. While 15% of your salary may seem unattainable when incomes are low or expenses are high, auto-escalation works by nudging employees to gradually increase their savings rate annually, much the same way that setting a specific goal to lose one pound per month can often be more successful than a general goal to lose 10 pounds.
- Eliminate your liabilities. Develop a systematic repayment strategy by consolidating your student debt and any consumer debt (i.e., credit cards) you had upon graduation. Aim to pay off your debt as soon as possible, remembering that not all debt is created equally. Online lenders, such as SoFi, generally have attractive rates for college graduates and will help you create a schedule to pay down debt over a set timeframe.
- Build your emergency savings. Single wage earners with no dependents can get away with saving 3-6 months of their living expenses in the event of an emergency expenditure or if they find themselves between jobs. If you work in a volatile industry or lack job security, consider increasing the size of your savings to cover a prolonged unemployment. Try to build this reserve as quickly as possible, and, once met, redirect the monthly savings to other priorities. A clever hack is to keep this reserve at a separate bank so that you’re not tempted to raid it when your spending creeps up.
- Establish additional retirement savings. Once you’ve addressed the above, reconsider your retirement savings. Generally, I advocate establishing an Individual Retirement Account (IRA)—specifically a Roth if you are within the IRS limits—rather than prioritizing your 401(k). However, this is dependent on the 401(k) plan design and features. As of 2018, individuals can contribute $5,500 annually to IRAs and $18,500 annually to 401(k)s and similar defined contribution plans. Consider the pros and cons of setting up a monthly contribution versus using an annual bonus or tax refund. While your income is low, take advantage of the tax benefits of a Roth. Although you don’t get an immediate deduction for your contributions, any growth and subsequent withdrawals are not subject to income taxes—a much more significant savings 40 years down the road. Unlike most 401(k) plans, IRA investment options are not limited, though it is important to evaluate the potential costs of each plan.
- Put the rest in taxable savings. Any excess cash flow should go to taxable savings, with the understanding that at different times in your life and according to your goals, taxable savings might take precedence over other options. For example, as you move toward marriage, you may find your needs lead you to prioritize saving for a down payment, while once kids arrive you’ll likely want to set up 529 plans. It’s most important to establish a plan that offers you flexibility throughout your life. Too often people fall victim to trying to design the perfect investment allocation instead of simply beginning the act of saving. What are you waiting for?
Some other helpful suggestions include:
- Automate. Setting up automatic transfers from your bank account will help ensure your various savings strategies remain on track and are not accidentally overlooked.
- Save first. I know people who deposit their paychecks directly into their savings accounts with bi-weekly automatic transfers into their checking accounts to cover budgeted expenses. This helps temper lifestyle creep when your expenses rise with your income.
- Fund a Health Savings Account (HSA)—and don’t touch it! If your cash flow can support this, consider enrolling in your company’s high deductible health care plan with an HSA. HSAs are different from Flex Spending Accounts (FSA) in that the contributions do not have to be used by the end of the pay year (i.e., “use it or lose it” provisions) and excess contributions can be invested. These funds are tax free when used to cover medical expenses, so if you can afford to fund your HSA and don’t need to withdraw these contributions to meet ongoing health expenses, your account can enjoy the benefits of compounding growth for several decades. Effectively, this is a Roth IRA for your future medical bills! An individual maximizing his annual contribution at $3,450 could see his HSA grow to almost $325,000 over 30 years, assuming 7% tax-free growth. That pot will come in handy if you one day need to replace knees and hips!
Life after college is the best time to take risks and try something different. As a young North Carolinian, I turned down an opportunity in nearby Charlotte to forge a new path in New York City. However, even while taking these risks—whether it’s a new city or a high-stakes career—it’s important to establish discipline around finances that can set you up for a lifetime of success. While I can’t time hop 17 years and convince my 22-year-old self to live in Brooklyn (back then it wasn’t as hip) instead of Hell’s Kitchen, I hope that these tips can help college graduates prepare for their new lives. After all, there’s no better starting point than right out of the gate with your first paycheck.
As a wealth management firm, Balentine is committed to providing peace of mind and simplicity to clients in all stages of life. Please talk to a Balentine relationship manager if you have additional questions about financial planning.