Easy Ways for Young People to Start Making Smart Financial Decisions by Jake MollerSubmitted by Moller Financial Services on September 29th, 2016
For young professionals who have just started thinking about their financial future, there is an endless amount of information to take in and questions to be asked. For most, retirement seems unattainable when you are young. Simplifying the daunting goal of retirement, I will outline several smart decisions you can make to put yourself on the right path.
Learning to view financial goals as short-term and long-term
The first step towards achieving your financial goals is to figure out what your goals are and when they will take place:
- When do I want to retire?
- When do I want to buy a house?
- When will I need to buy a new car?
While this may seem a simple task, learning to view your financial future in the prism of short-term goals versus long-term goals is of critical importance. Investing for short-term goals is very different than investing for the long haul.
Short-term goals may include purchasing a house in three years or taking a vacation to Europe this year. As a rule of thumb, any goals under five years should be treated as short-term. The nature of short-term goals is that you shouldn’t take much risk because you will need the money within the next five years or so. Therefore, investments for the short-term goals should be very conservative (think cash, short-term bonds or CDs).
Long-term goals include retirement in 25-35 years or paying for your child’s college tuition in 18 years. Since these goals are further into the future, your investment time frame enables you to withstand the volatility of markets and benefit from the long-term growth.
Before you can determine what money to invest, what money to keep in cash, and what investment vehicle in which to allocate your savings, you must first differentiate between short-term and long-term goals.
If you have money earmarked for retirement or another long-term goal, the biggest threat to not achieving these goals is to keep your money in cash. Time is the biggest asset for young investors. Getting started now, even if it is a small amount, is the most important thing you can do. Consider increasing your annual savings by a percentage each year (many 401(k)s offer an automatic increase) with a goal of saving 15-20% of your income.
When taking a close look at returns of the S&P 500 over the last year, you may see some significant upward and downward swings. However, if you look at how the market has performed over longer periods of time, you notice that over time the downward swings tend to become small blips and the overall upward trend becomes clear. Over time, markets go up, and if you want to create future wealth you can’t have all of your savings sitting in cash.
Saving to a company sponsored retirement plan
If your company offers a 401(k) or similar retirement plan, it can be a great vehicle for laying the foundation to a successful retirement. 401(k) contributions are pulled directly from your paycheck, making the savings “automatic”. The biggest benefit of a 401(k) is that often the company will match a portion of your contribution. We look at this company match as FREE MONEY! Anyone with a 401(k) plan should contribute at least enough to get the full company match. Another major advantage of 401(k) plans is the tax-deferred savings, meaning you won’t have to include your contributions as taxable income. While the money will eventually be taxed when you make withdrawals, the current tax savings and deferral of taxes until that time make it a great place to invest for retirement.
Saving to a Roth 401(k) or Roth IRA
Roth 401(k)s and Roth IRAs are retirement accounts that provide excellent tax-advantaged investment vehicles. While there are no tax savings in the current year on contributions, Roth 401(k)s and Roth IRAs do provide tax-free distributions once you have reached age 59½. For young investors, they may be in a lower tax bracket in their early working years so they may be better off using a Roth 401(k) instead of a traditional 401(k) since current tax savings are not as significant.
Roth 401(k)s are typically offered as an option within a traditional 401(k). One important thing to note about Roth 401(k) contributions is that any employer match will actually be added to a traditional 401(k). Contributing to a Roth 401(k) does not exclude you from receiving the employer match. While employees can make Roth contributions, employers can only contribute to traditional 401(k)s.
Roth IRAs are individual retirement accounts that can be opened regardless of your employer-sponsored plan as long as your annual income is below $117,000 for single taxpayers or $184,000 combined income for married taxpayers in 2016. While Roth IRAs are intended for retirement savings, there are circumstances where contributions can be taken out before age 59½ without tax or penalty. This can be helpful if money is needed down the road for unforeseen expenses or different financial goals (down payment on a house, etc.).
If under age 50, the maximum someone can contribute in 2016 is $18,000 to a Roth 401(k) and $5,500 to a Roth IRA. For anyone 50 or older, the contribution limit is $24,000 for a Roth 401(k) and $6,500 for a Roth IRA. Roth IRAs are a great place to put additional retirement savings.
401(k)s, Roth 401(k)s, and Roth IRAs provide great tax-advantaged savings vehicles for retirement and it is important to utilize these accounts primarily for long-term goals. Each account can trigger taxes and penalties if withdrawn before age 59½.
While retirement may seem daunting and far down the road, the best time to start making good financial decisions is now. Utilize these simple steps to lay the groundwork for a strong financial future.