May is the month of college graduations. Graduates, their family and friends celebrate, reflecting on how far the student has come and the promise of his future. The graduate is transitioning from academic life to the “real” world. Finances are a significant part of that world. Habits established the first few years of working life set the precedent for financial stability in the future. What should the graduate do?
The first step to financial success is a budget. Estimate all your expenses (rent, utilities, student loan payments, other debt payments, food, car or commuting costs, savings, any other recurring payments. List all sources of income. For salary, use take-home amount. Otherwise, you must include salary deductions for taxes as expenses. Subtract total expenses from total income. Hopefully, you’re not in the red – more expenses than income. If so, look for expenses that can be cut. Track your expenditures, compare to your plan, at least monthly. The process is iterative, adjusting as things change.
Managing debt and becoming a good credit risk is essential to accomplishing long term goals of acquiring those big ticket items (a car, a house) and eventually supporting your family. College graduates often finish school with student loan debt and credit card debt.
Credit card debt is expensive. Finance charges on outstanding balances can be very high. Any debt incurred during student days should be paid down as quickly as possible. Pay more than the minimum on the credit cards with the highest rates. Pay on time to avoid late fees. Late payments adversely impact credit rating. If a credit card charges an annual fee consider closing it. But don’t divest yourself of all cards. Your credit score will be higher when the total amount owed is low compared to the total credit available. Keep the credit, just don’t use it. Only use the credit when you know you have the funds to pay for the purchase in full when the bill comes in.
Student loans. Know the terms of your student loans. If you have multiple loans, look to consolidate them. This will help you manage the loan and often makes the monthly payment lower. Investigate an income based payment plan. With this plan, loan payments start out lower and increase as your income increases.
The habit of saving should begin with the first paycheck. Called “paying yourself first”, some amount of money should be saved before you access the remainder for regular expenses. Automatic transfer to an account can often be set up with your employer. Ideally, you should save 10 to15 percent of your income. But if you can’t manage that, start with $25 to $50 a pay period. The key is to start.
Emergency fund. The first savings goal is to build up a 3 to 6 month emergency fund. This is to cover rent, utilities, and basic living expenses if you should lose your job. Keep it in a liquid account (bank savings), don’t touch it. It’s for an emergency, not for the trip your colleagues are planning to Vegas.
Retirement. It’s hard to think of retiring when just starting a career but the best way to secure a comfortable retirement is to start early. It is especially important to new employees since employers have cut back on employer funded pension plans. If your employer offers a 401k retirement savings plan, participate as soon as you qualify. Your contribution lowers your taxable income. The employer often matches a percentage of your contribution. Make sure you contribute enough to take advantage of the full matching. Where else can you earn 100% on your money?
If your employer doesn’t offer a 401k or participation requires you wait a year to qualify, consider a Roth or traditional IRA. The traditional IRA may lower your taxable income now, contributions and gains are not taxed until withdrawals which can’t start until you reach age 59 ½. If you access the money before then, you will pay a 10% penalty. A Roth IRA is funded with after tax dollars. The gains are not taxable. Withdrawals are to start at 59 ½ years of age. However, if you hold the Roth for five years and then need the money, you can take out your contribution with no penalty.
401k and IRA funds may be invested in various financial instruments: certificate of deposits, stock funds, bond funds, etc. Each of these instruments has a level of risk, from none (CD’s) to high (aggressive growth stock funds) with a related potential for growth. It is important to learn about the options available. Don’t avoid saving because you are a novice. Start accumulating the funds, investing in what you understand.
Curb the Splurge
A steady paycheck may seem like a financial windfall to a recent college student. Exercise restraint. Is the new car really necessary at this stage? We all have heard about how a new car depreciates when driven off the lot. A first apartment may be more affordable with roommates. Do you really need those premium channels? The choices made now establish spending habits for the future.
Taking responsibility for personal finances and building financial security is an integral part of the graduate’s transition to the “real” world. Some of these topics may be new. Read, investigate, question. The learning mustn’t stop.
IRS Circular 230 Disclosure
Pursuant to U.S. Treasury Department Regulations, we are now required to advise you that any federal tax advice contained in this communication, including attachments and enclosures, is not intended by the Sender or Sandra G Johnson, CPA, P.C. to constitute a covered opinion pursuant to regulation section 10.35 or to be used for the purpose of (i) avoiding tax-related penalties under Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.