Smart Financial Moves for College Graduates

Jane Young, CFP, EA

Jane Young, CFP, EA

After finishing school and hopefully landing a rewarding job, college graduates face a myriad of financial obligations and opportunities.   Here are some steps for graduates to get started in the right direction.

Create a Budget and Live Below Your Means – Based on your income, create a spending plan that leaves you with a little extra money at the end of the month.  Your budget should include saving at least 10% of your gross income.  Spend less than you earn so you are prepared for unexpected bumps in the road.  Initially this may involve renting a smaller apartment, living with roommates or driving an older car.  As your career progresses, avoid increasing expenses in lock step with earnings increases.

Establish an Emergency Fund – With the money you are saving, build and maintain an emergency fund equivalent to 4 to 6 months of expenses.

Avoid Credit Card and Consumer Debt – Pay your credit card bill in full at the end of every month.  If you can’t afford to pay for your purchases when the bill arrives then postpone or re-evaluate the purchase.   Avoid or minimize debt on vehicles and other consumer purchases.

Payoff Student Loans – Devise a plan to payoff your student loans.  Consider consolidating or refinancing your loans if it will save you money.  Consider both the interest rate and the duration when evaluating loans.  Generally, you want to pay off student loans in less than ten years.

Buy Adequate Insurance – It’s essential to have good health insurance coverage; if you aren’t covered by your employer you may be eligible for continued coverage on your parents plan.  You will also need good car insurance and renters insurance on your apartment.  Additionally, consider long term disability insurance and an umbrella liability policy.

Contribute to Your Employers Retirement Plan – Many employers offer a 401k or 403b plan to help you   save for retirement using before tax dollars.  At the very minimum contribute up to the match that your employer may provide.

Contribute to a Roth IRA – Once you start earning money you can also save for retirement by contributing to a Roth IRA.  The benefit of a Roth is since you initially invest with after tax dollars, you don’t pay taxes when the money is withdrawn in retirement.   This is a tremendous opportunity for recent college graduates because your money can grow tax free for forty or fifty years.

Travel and Have Some Fun – While you’re young and relatively independent, set aside some money to explore the world or do something adventurous.  Once you buy a house, start a family or assume more job responsibilities it’s harder to get away.

Educate Yourself on Finances – Start reading personal finance books and articles.  Here are a few books to consider; “The Money Book for the Young, Fabulous and Broke” by Suze Orman, “Personal Finance for Dummies” by Eric Tyson, and “The Millionaire Next Door “ by Thomas J. Stanley and William Danko.

Invest in Roth IRAs with Caution

Jane Young, CFP, EA

Jane Young, CFP, EA

A Roth IRA can be an excellent vehicle to save for retirement but it’s not without limitations.  With a Roth IRA you invest after-tax dollars that grow tax free and can be withdrawn tax free in retirement. This can be beneficial unless you are currently in a high tax bracket and anticipate being in a lower tax bracket in retirement.

Income limitations can be a significant downfall with Roth IRAs.  During your highest income years you may be ineligible to invest in a Roth IRA and there can be substantial penalties for making ineligible contributions.  In 2015 the income limit for someone filing single begins at $116,000 and the income limit for someone filing married filing jointly begins at $183,000.  If you make a contribution and your income exceeds the limitations, you have until your tax deadline, including extensions to withdraw your contribution.  It’s easy to inadvertently make ineligible contributions and there aren’t many red flags to alert you to the problem.  If you don’t withdraw excess contributions within the deadline you will incur a 6% penalty for every year the money remains in your Roth IRA.

Also be careful not to exceed the annual Roth IRA contribution limits.  In 2015 the contribution limit for investors under 50 is $5,500, if you are over 50 you can make an additional catch-up contribution of $1,000. Also keep in mind that Roth IRA contributions can only be made with earned income.

If your earnings exceed the income limitations and you still want to participate in a Roth IRA, you may have several options.   Your employer may offer a Roth 401k in addition to a traditional 401k.   With a Roth 401k, your employee contributions can go into the Roth option but the employer match must go into a traditional 401k.  A second option is to convert a traditional IRA to a Roth IRA but the amount converted is taxed as regular income in the year of conversion. As a refresher, with a traditional IRA and 401k you invest with before tax dollars and you pay regular income tax on the full amount when you withdraw the money.  Finally, you can consider investing in a non-deductible IRA and immediately convert it to a Roth IRA, also known as a backdoor Roth IRA.

Initially, the backdoor Roth sounds like the perfect solution because there is no income limitation on a non-deductible IRA and it’s funded with after tax dollars. Theoretically, immediate conversion to a Roth IRA should be tax free. The hitch comes from the IRS rule requiring you to aggregate all of your IRAs and proportionately include money from all IRAs in your Roth conversion.  Traditional and rollover IRAs are comprised of pre-tax dollars so the proportion of the conversion coming from these IRAs will be taxed as regular income.  Although backdoor Roth IRAs can be complex but they can be a good option if you don’t own other IRAs.

Tax Diversification Can Stretch Retirement Dollars

Jane Young, CFP, EA

Jane Young, CFP, EA

Most investors understand the importance of maintaining a well-diversified asset allocation consisting of a wide variety of stock mutual funds, fixed income investments and real estate.  But you may be less aware of the importance of building a portfolio that provides you with tax diversification.

Tax diversification is achieved by investing money in a variety of accounts that will be taxed differently in retirement.   With traditional retirement vehicles such as 401k plans and traditional IRAs, your contribution is currently deductible from your taxable income, your contribution will grow tax deferred and you will pay regular income taxes upon distribution in retirement.  Generally, you can’t access this money without a penalty before 59 ½ and you must take Required Minimum Distributions at 70 ½. This may be a good option during your peak earning years when your current tax bracket may be higher than it will be in retirement.

Another great vehicle for retirement savings is a Roth IRA or a Roth 401k which is not deductible from your current earnings.  Roth accounts grow tax free and can be withheld tax free in retirement, if held for at least five years. If possible everyone should contribute some money to a Roth and they are especially good for investors who are currently in their lower earning years.

A third common way to save for retirement is in a taxable account.  You invest in a taxable account with after tax money and pay taxes on interest and dividends as they are earned.  Capital gains are generally paid at a lower rate upon the sale of the investment.  In addition to liquidity, some benefits of a taxable account include the absence of limits on contributions, the absence of penalties for early withdrawals and absence of required minimum distributions.

Once you reach retirement it’s beneficial to have some flexibility in the type of account from which you pull retirement funds.  In some years you can minimize income taxes by pulling from a combination of 401k, Roth and taxable accounts to avoid going into a higher income tax bracket.  This may be especially helpful in years when you earn outside income, sell taxable property or take large withdrawals to cover big ticket items like a car.  Another way to save taxes is to spread large taxable distributions over two years.

Additionally, by strategically managing your taxable distributions you may be able to minimize tax on your Social Security benefit.   Your taxable income can also have an impact on deductions for medical expenses and miscellaneous itemized deductions, which must exceed a set percentage of your income to become deductible.  In years with large unreimbursed medical or dental expenses you may want to withdraw less from your taxable accounts.

Finally, there may be major changes to tax rates or the tax code in the future.  A Tax diversified portfolio can provide a hedge against major changes from future tax legislation.

Retirement Tips for All Ages

Jane Young, CFP, EA

Jane Young, CFP, EA

It’s always a challenge to balance between current obligations and saving for retirement.  A good start toward meeting your retirement goals is to get your financial house in order.  Create a spending plan that helps you live below your means.  Maintain an emergency fund of at least four months of expenses and pay off high interest consumer debt.    Establish a habit of saving at least 10% of your income.  If you are getting a late start, you may need to save 15-20% of your income.

Develop a retirement plan to determine how much you need to save on a monthly basis and how large a nest egg you will need to comfortably retire.  There are many on-line calculators available to help you run retirement numbers.  However, they are only as accurate as the data that you input and the assumptions that the model uses.  You may want to hire a fee-only financial planner to run some figures for you.

Work toward maximizing contributions to your employer’s retirement plan; take advantage of any employer match that may be provided.  Once you have contributed up to the level of your employer’s match, consider contributing to a Roth IRA.  A painless way to steadily increase your contribution percentage is to increase your contribution whenever you get a raise.  If you are self-employed, or your employer doesn’t offer a retirement plan, contribute to a SEP, Simple or an IRA.  If you are maxed out, increase your contributions as the maximum contribution limits increase or you become eligible for a catch-up contribution at age 50.

Invest your retirement funds in a diversified portfolio made up of a combination of stock and bond funds that invest in companies of different sizes, in different industries and in different geographies.  Generally, your retirement savings is long term money, so avoid emotional reactions to make sudden changes based on short term market fluctuations.  Develop an investment plan that meets your timeframe and investment risk tolerance and stick to it. 

Don’t use your retirement funds as a savings account for other financial objectives.  Unless you are in a dire emergency, don’t take distributions or borrow against your retirement funds.  When you change jobs, don’t cash out your retirement plans.  Roll your funds over to an IRA or a new employer’s plan.    Avoid sacrificing your retirement savings to fund college education for your children.

As you near retirement age, there are several ways to stretch your retirement dollars.  Retirement doesn’t have to be all or nothing.  Consider a gradual step down where you work a few days a week or on a project basis.   Try to time the payoff of your mortgage with your date of retirement.  Consider downsizing to a smaller home or moving to a more economical area.  Establish a retirement spending plan that provides funds for things you value and helps you avoid frivolous spending on things that don’t really matter.

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