Making Smart Financial Decisions as a Young Adult (Part 1)
Managing personal finance and making smart investment decisions are some of the most complex issues that most if not all young adults contend with. Today’s post highlights solid financial choices young adults can make when it comes to saving, paying off debt, and purchasing a home to guarantee a sound financial future.
Saving is one of the primary decisions many young adults must get accustomed to as they transition into life in the corporate world. A key question to ask is: Exactly how much do I save? Obviously, the answer to that is never straightforward as there are some key aspects to consider before making an accurate decision. Saving early is extremely important! The following is an illustrated example from buckinghamadvisor.com that explains why:
Imagine the year is 2051 and Mary-Kate and Ashley are 65 years old. Starting at age 20, Ashley started saving $2,000 per year in an Individual Retirement Account (IRA). After 20 years of contributions, she stopped making new contributions. Her investments returned 7 percent per year, and the account is not taxed until the funds are withdrawn.
Mary-Kate, on the other hand, did not start saving until age 40, and she saved $2,000 per year in her IRA for 25 years. She made her last contribution in 2051. She also earned a 7 percent return on her investments. Mary-Kate saved for five more years than Ashley, but she started saving much later. Who ended up with more money? Ashley wound up with $476,151 while Mary-Kate’s ending balance was $135,353.
Let’s make a change to this example to emphasize the importance of saving early. What if Mary-Kate is the next Warren Buffett? Let’s say she earned 14 percent while Ashley still earned 7 percent. Mary-Kate’s ending balance of $414,665 still fell short of Ashley’s $476,151 despite Mary-Kate earning more than twice as much as Ashley on her investments.
Roth IRA Versus Traditional IRA
Young adults may need to decide between opting for a Roth 401(k) and a traditional 401(k) when it comes to making contributions to their respective company retirement plans. A Roth 401(k) enables a saver to contribute to your 401(k) plan with after-tax income and increase the saved money free of tax. At retirement, withdrawals from a Roth 401(k) are not taxed.
On the other hand, a traditional 401(k) allows a saver to contribute to a 401(k) plan with pre-tax income, which will grow tax-free. The difference here is, at retirement, withdrawals from a traditional 401(k) will be taxable. It is also very important to know that the key to this decision is a saver’s current tax bracket versus his or her tax bracket in retirement.
The Roth 401(k) is beneficial when a saver expects to be taxed at a higher rate once retirement hits. Conversely, when a saver anticipates a lower tax rate in retirement, the traditional 401(k) makes more sense. In the case of most individuals, the retirement tax bracket could be unknown so in such cases it makes a lot of sense to split retirement savings between a traditional and a Roth 401(k).
Paying Off Debt
The subject of paying off debt gets very tricky in that the idea of diversification works against any debtor or borrower. Interest rate is always an important factor to consider as far as paying off debt is concerned. To make the smartest choice, it is advisable to decide prioritizing between saving and paying off debt. Here are some guiding principles to explain the order of the aforementioned statement thoroughly:
•Save in your 401(k) as this results in maximum employer match. Think of it as “free money,” and without saving enough you don’t take full adavantage of employer contributions.
•More often than not, debt owed on credit cards has the highest interest rate so it makes sense to pay them down.
• The next focus is to pay down other non-deductible loans. A car loan could be considered a non-deductible loan.
• Take advantage of tax-deferred accounts for saving purposes.
• Pay down deductible loans such as student loans and mortgages. In the case of paying down a student loan, it’s important to consider eligibility for a loan forgiveness program. State officers usually qualify for such programs.
•Save to a taxable account.
Purchasing Versus Renting a Home
Purchasing a home is one of most important financial decisions anyone can make because it is always carries future implications. Two key areas to consider before purchasing a home are diversification in terms of financial assets and the ability to be mobile.
Young adults normally possess little to no financial assets. It is very important to build some savings before purchasing a home, as it allows a diversified financial portfolio. In the case of most young adults, their mid-thirties is a realistic time to start looking into a first home purchase since they most likely would have some savings and assets to their name.
Purchasing a home ties a buyer to a particular city or community and could possibly be a limiting factor to future career openings. If a career requires moving frequently, it would be advisable to pay closer attention to the numbers before purchasing a home. Owning a home for less than 5 years may not necessarily be the smartest decision.
Is saving an area of strength for the potential buyer? If the response is no then buying a home enables a homeowner to save money in terms of home equity. It’s a more costly approach to saving when interest is factored in. Nonetheless, it still provides one of the easier ways to accumulate savings aside from a 401(k).
Tips for Buying a Home
To purchase a home, it is important to save for a down payment which is usually 20 percent; this helps to do away with the extra cost of private mortgage insurance. It is also important to know how much a buyer can comfortably afford before going for a prequalified mortgage at a local bank or through a mortgage broker. It is smart to buy a house lesser than your qualified amount and understand the different mortgage options- a fixed or variable rate, and the mortgage term just to name a few.
Finally, in the case of married couples, it is very important to consider what your partner desires in terms of deciding between buying or renting a home. The amount saved in total based on the final decision would only be meaningful if your partner is happy, hence it would make the most sense for both parties to fully understand the financial implications.
The Parable of the Talents
14 “For the kingdom of heaven is like a man traveling to a far country, who called his own servants and delivered his goods to them. 15 And to one he gave five talents, to another two, and to another one, to each according to his own ability; and immediately he went on a journey. 16 Then he who had received the five talents went and traded with them, and made another five talents. 17 And likewise he who had received two gained two more also. 18 But he who had received one went and dug in the ground, and hid his lord’s money. 19 After a long time the lord of those servants came and settled accounts with them.
20 “So he who had received five talents came and brought five other talents, saying, ‘Lord, you delivered to me five talents; look, I have gained five more talents besides them.’ 21 His lord said to him, ‘Well done, good and faithful servant; you were faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’ 22 He also who had received two talents came and said, ‘Lord, you delivered to me two talents; look, I have gained two more talents besides them.’ 23 His lord said to him, ‘Well done, good and faithful servant; you have been faithful over a few things, I will make you ruler over many things. Enter into the joy of your lord.’
24 “Then he who had received the one talent came and said, ‘Lord, I knew you to be a hard man, reaping where you have not sown, and gathering where you have not scattered seed. 25 And I was afraid, and went and hid your talent in the ground. Look, there you have what is yours.’
26 “But his lord answered and said to him, ‘You wicked and lazy servant, you knew that I reap where I have not sown, and gather where I have not scattered seed. 27 So you ought to have deposited my money with the bankers, and at my coming I would have received back my own with interest. 28 Therefore take the talent from him, and give it to him who has ten talents.
29 ‘For to everyone who has, more will be given, and he will have abundance; but from him who does not have, even what he has will be taken away. 30 And cast the unprofitable servant into the outer darkness. There will be weeping and gnashing of teeth.’
Lesson: Saving for your future and retirement can be likened to the servants who were given five and two talents respectively. They invested their talents and reaped more to present to their master upon his arrival. Make hay while the sun shines!
God loves you!