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Advice for Recent College Graduates
Forget the Cappuccinos, for Now
In September recent college graduates are starting their first jobs. Parents sometimes ask us to give their children some general guidelines as they begin their working careers.
You may have a child, grandchild or some other young person in your life who could use the same guidance. If so, please pass on these ideas, which we hope will help many young people establish good financial habits that will last them for their lifetimes.
1. Develop a Budget
Once you know what you’ll be earning at your new job, set up a budget right away and try to stick to it. Whether you’re paid every two weeks or once a month, your starting point should be your monthly income. Keep in mind that your take-home pay may be significantly less than what you initially expect because of deductions for federal and state taxes, Social Security and health insurance. You may be shocked to find out how little is left when you open that first paycheck.
Next you need to list expected expenses. The easiest ones to compute are fixed expenses — the ones you know you’ll incur each month, such as rent, transportation to work, car payments and student loan payments. (Actually, unless you really think you can afford the payments, we suggest you postpone buying a car, if possible, until you have accumulated some money.)
Then factor in an amount for variable expenses such as food, clothing, travel and entertainment. As part of this budget, we urge you to immediately start setting some money aside for savings — ideally 5 percent to 10 percent of your gross pay. This “pay yourself first” approach enables you to accumulate a cash reserve to take care of unexpected expenses so that you don’t have to go into debt to pay them.
If you’ve never lived on a budget before, write down everything you spend for three months. Then compare it with the initial budget you put together. You may be surprised when you see some of the frivolous things you’re buying each month (Starbucks, anyone?). Once you know how you spend your hard-earned money, you can eliminate the less essential expenditures.
We recommend keeping some kind of record of your income and expenses for this first working year. When you get a raise, make sure to allocate some part of it to be saved as well.
2. Pay Off Student Loans
Most college graduates leave school in debt with student loans. You do have to repay these loans, so don’t ignore the notices when they start coming in and make sure you include payments in your budget. You could end up with multiple payments because you may have taken the loans out at different times.
If that’s the case, consider consolidating your student loans so that you have one payment. You also may be able to find a better interest rate than your current one.
To do this, shop around by contacting local banks, Sallie Mae (the largest provider of student loans) and American Education Services, a full-service financial aid organization.
3. Establish Credit
Most college students are offered credit cards while still in college. Actually, we’re appalled at how easy it is for students without a visible form of income to get credit. These little plastic cards can be useful but also can mean you’ve accumulated debt even before graduating from college.
When you graduate, you’ll have some transition expenses such as renting an apartment, which may require putting down a month’s rent as a deposit; furnishing your new place; and buying a new wardrobe for work. It can be helpful to pay for some of these expenses, such as new clothes or furniture, with a credit card because you may not have the cash to pay for everything you need right now.
But please understand this is real money you’re spending, not plastic. It’s tempting to pay only the minimum due when the bill arrives, but if you do this you may never pay off the bill because of the impact of compounding interest on this debt.
Avoid having multiple credit cards. Try to concentrate on one or at most two, and sign up for one with the lowest interest rate available. Credit card companies often offer low teaser rates to entice you to use their cards, but generally after a certain period, the rates become very high. Keep in mind this interest isn’t tax-deductible.
Establishing credit in your name and showing a consistent pattern of paying off debt is important for buying a home or a new car later, but you don’t want to take on more debt than you can handle. Ideally you wouldn’t charge more than you can afford to pay off each month.
That may be hard to do in your first few months of working, but it should be your ultimate goal by the end of the first year. If you receive bonuses at your new job, be sure to use at least part of them to pay off your credit cards.
4. Understand Your Medical Insurance
Now that you’re not a dependent of Mom and Dad, you’ll become responsible for your own medical insurance. Most employers offer it, and it’s important that you spend some time studying the options under your employer’s plan. Ask a human-resources representative at your firm to help if you don’t understand the differences between the kinds of coverage offered.
If multiple options are provided, sign up for the program that best meets your needs by comparing the variety of coverage options, doctors included in each plan, services covered and cost. Your employer typically pays part — but not all — the monthly premium as well. You’ll pay at least some of the cost when you incur actual medical expenses.
Whatever you do, don’t go without medical insurance. In our early 20s, we tend to think we will always be healthy; medical insurance isn’t high on our list of priorities. But all it takes is one accident or unexpected illness to understand its true value.
5. Build Your Retirement Fund
Your new employer typically will offer some sort of a retirement plan such as a 401(k) or 403(b). Sign up for it as soon as you can and try to contribute the maximum you can. Whatever you invest in a retirement plan reduces your current taxes because these contributions won’t be currently taxed. This money grows tax-deferred, which allows you to accumulate more over time. And when you get a raise, increase the amount you’re contributing to your retirement plan.
In addition, your employer may even match the amount you’re investing in the plan. So if you can’t afford to invest the maximum, at least invest as much as is being matched.
Check into what happens to the matching money. Sometimes you have to stay a certain amount of time before you’re vested in this matching money. This means if you leave before the required time, you’ll forfeit the matching money. But the amount you contribute plus what’s earned is always yours to keep.
Although retirement may seem like a long way away when you’re just graduating from college, try to start this plan right away. Investing small amounts early in your career means you won’t have to put as much away later in life for retirement, which will free up money for you to do other things you may enjoy.
For example, if you contribute $2,400 per year for 35 years to a retirement plan and that money earns an average annual return of 8 percent, it will grow to $446,645 at the end of that time. To illustrate how important it is to begin saving as soon as possible, if you don’t save anything for the first 10 years and then begin to save $2,400 per year for the next 25 years, you’ll accumulate only $189,491 at the end of that period. That’s only 42 percent of what you could have saved.
Having time on your side and beginning at a young age are what make the difference. And if you can save more than we’ve illustrated, these numbers will improve greatly.
6. Choose Between a Roth IRA and Your Employer’s Retirement Plan
In the case of 401(k), 403 (b) and 457 plans, you can contribute as much as $15,500 annually (assuming you earned this amount). You’d receive a deduction of $15,500 from your taxable income, the money would accumulate tax-deferred and when you retire, whatever you take out is taxed.
In addition (or instead), you can contribute as much as $5,000 to a Roth IRA* (assuming you earned that much). The difference between doing this and contributing to your employer’s retirement plan is that you don’t get a deduction for making a Roth investment. As with a 401(k), any money your Roth IRA earns accumulates tax-deferred. And best of all, when you finally do retire, whatever you take out of a Roth IRA is tax-free.
Of course, most people can’t afford to take this much out of their paychecks initially, as they wouldn’t have anything left to pay the rent and eat. Most advisers recommend that young workers contribute first to a Roth IRA, since typically this is the lowest tax bracket they’ll ever be in. But we recommend you consider investing something in your retirement plan at work, even if it’s the bare minimum. Also, if you have affluent and generous parents, they might help you fund the Roth IRA, your employer’s retirement plan, or both.
With the 401(k), more of your money gets invested right now. With the Roth, less is invested right now, but you don’t pay any tax down the road. The Roth IRA eventually will be more beneficial taxwise. 401(k)/403(b) plans allow you to get more money working right now.
To illustrate how these plans work, let’s say you’re single, are in the 15 percent federal tax bracket (your taxable income is less than $32,550 in 2008) and decide to invest $100 per month from your paycheck for retirement savings. The $100 goes pre-tax into the 401(k) each month for a total investment of $1,200. It grows tax-free, and when you start taking distributions, you owe income tax on the distribution.
If you invested the same amount into a Roth, the $100 gets paid out to you as part of your salary, but taxes are taken out. Let’s say withholding rates are 15 percent for federal taxes and 5 percent for state taxes. This leaves you with $80 to invest in your Roth each month, for a total of $960 for the year. It grows tax-free, and when you start taking distributions, you won’t owe any income tax.
One advantage of 401(k)/403(b) deductions is they’re taken from your paycheck automatically. You select where to invest your money from a list of options provided by your employer. In the case of a Roth IRA, you have to establish it on your own and select the investments. The 401(k) really forces you to save because it happens automatically, and your contribution is locked in until the next open period, when you can change the amount you invest. Some people need that forced savings element to stay disciplined.
7. Build a Cash Reserve
When you’re facing all these initial expenses, it’s hard to think about building a cash reserve. But as we mentioned before, it’s important to build a nest egg of cash in the event of an emergency such as your car needing repair (another reason not to buy one!). Your ultimate goal is to have three to six months’ worth of expenses in a cash account. You won’t know what those expenses are unless you’ve done a budget.
Once you accumulate enough in your cash reserve account, you can begin investing any excess cash you earn each month into other types of investments. This can help fund future goals such as purchasing a new home or taking a special vacation.
If you have to choose between building your retirement funds and adding to your cash reserve, we recommend building your retirement fund but suggest trying to build your savings at the same time.
Establishing good financial habits early in your career will reward you over your lifetime. Although disciplining yourself financially will be hard at first, you’ll find it very worthwhile when you finally gain control of your financial future.
Alexandra Armstrong is a certified financial planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment advisory firm located at 1850 M St. N.W. in Washington, D.C. Securities are offered through Commonwealth Financial Network, a member of FINRA/ SIPC. Investment advisory services are offered through Armstrong, Fleming & Moore, Inc., an SEC-registered investment adviser not affiliated with Commonwealth Financial Network.
Consult your personal financial adviser before making any decisions.
Ms. Armstrong can’t answer individual questions, but she welcomes suggestions for future article topics.
This material has been provided for general informational purposes and does not constitute either tax or legal advice. Investors should consult a tax or legal professional regarding their individual situation. The fifth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being,
co-authored by Alexandra Armstrong and Mary R. Donahue, is available on Amazon. com, Kindle and Nook.