As we live out our 20’s we often wonder if we are making the right financial moves. Credit card debt, car loans, and student loan debt are all too common among Millennials. We hear it all the time that it is becoming more and more difficult to retire and that the American dream of retiring with wealth is dead. However, there are a number of financial moves we can make before age 30 that will put us on a path toward financial success.
Do not be Afraid of the Market
Having lived through the Great Recession that started in 2008, we as generation are weary to invest in the stock market. Throughout history there have been several 30-40 percent declines in the stock market. Baby Boomers and those close to retirement when the financial crisis hit saw their life savings cut in half. However, in our 20’s and early 30’s we are too far away from retirement to worry about such a downturn.
If we decide to invest less in risky assets like stocks, and keep more of our money saved in cash and bonds, we will miss out on significant stock market returns over the long haul. While being too risky and investing it all in the stock of a particular company is not a smart move, the opposite: “risking” it all in bonds and cash is also not a smart move. Early on in our working careers, we can afford to invest in assets that carry more financial risk. In the event of a large downturn, we have a time horizon long enough to allow our retirement accounts to recover. Heck, maybe even those of us that are smart will buy more when the market takes a big downturn! After all, that’s how all of the biggest investors make their money. Buy low, and sell high.
The general rule of thumbs for how much money you should have in stocks and bonds is: 100 minus your age = percentage in stocks. Your age is the percentage in bonds or other low risk investments.
Diversify in Assets and Tax Situations
Everyone should know that you need to be well diversified in your investments. You should never invest all of your money in one company’s stock or in one sector of the market. Likewise, you should not invest all of your money in one type of account.
For example, if all of your money is held in a company sponsored 401k plan or in an IRA, you will definitely owe a significant portion of it to the Federal Government when it comes time to take withdraws from those accounts (Yay, the IRS! …sarcasm). Contributions to these accounts are made on a pre-tax basis and earnings grow tax-deferred. However, you will pay income taxes on whatever you withdraw in retirement.
You should invest your money in various types of accounts due to the tax implications. If you qualify to invest in a Roth IRA, you should definitely consider it. IRS income limits for those filing jointly are $194,000. Luckily, there are still ways to fund a Roth IRA if you make more than this amount which I will get to later. You fund a Roth IRA with after-tax dollars but earnings grow tax-free and you are not taxed when it is time to withdraw either because you already paid taxes on the money before it went into the account. I especially recommend a Roth IRA if you think you will be making more money in retirement than you make right now, as you will owe less taxes now, and more in the future.
Beyond a Roth IRA, you can open a brokerage account. You fund this account on an after-tax basis just like a Roth IRA however, if you invest properly, you will only owe long term capital gains taxes on your investments. The long term capital gains tax currently sits at 15% which is significantly less than the income tax of a median salary earning American worker. Furthermore, if you play your cards right and are aiming to retire early, a brokerage account is the way to go as there is no penalty on making withdraws before you reach the age of retirement at 59.5.
Do not Succumb to Lifestyle Inflation
So you make more money than you thought you would be making before age 30? Great problem to have no matter which way you look at it, but if you blow that extra income on things that you think you “need” you may be putting your long term financial goals in jeopardy in order to have a more luxurious lifestyle. This is something that you will be kicking yourself for as you get closer to retirement.
Over your career, you will most likely get consistent raises. These raises should be used to increase your retirement savings or savings toward short term goals like buying a house. Avoid the mistake of ramping up your current lifestyle because you got a big promotion because your retirement and other financial goals will suffer immensely.
Fire up the Savings for Later-in-Life Healthcare Expenses
This one may seem crazy for most young and healthy folks but it is a very wise thing to do. Open a Health Savings Account so you can save money for health related expenses like trips to the doctor, prescriptions, and surgeries, heck, most forms of birth control are even considered healthcare expenses. The really great thing about this type of account is that you fund it with pre-tax dollars and you do not pay taxes on the money when you use it for qualifying healthcare related expense. So, yes, you never have to pay taxes on this money as long as you use it for the intended purpose. Another great thing about this account is that a portion of it can be invested in various investment options and it is allowed to grow tax free. By the time you are using a large portion of this money when you are older, you could have a very nice chunk of change built up in this account.
The IRS currently limits you to yearly contributions of $3350 for individuals and $6750 for families (2016). An HSA is a great way to hedge against future medical expenses. It may not be a sexy place to save and invest your money as young and healthy individual, but 65 year old you will sure be happy you did. The best part, the money is always yours and does not expire like a Flexible Savings Account.
Do Not Set Yourself Up For Failure
Too many times people leave their money out of investments or in low risk, low return investments for too long. Some people try to “time the market,” which very rarely works in your favor. Others invest too heavily in the same type of industry that they work in.
Investors need to focus on what they can control and not set themselves up for failure by making these common errors above. Diversification is the key to investment success over the long term. The market will swing up and down. Do not try to time it. If you are well diversified, your losses will be mitigated more so than if you were heavily invested in one industry and that particular industry had a downturn. Likewise, avoid investing a large portion of your money in the industry in which you work. You, yourself are an investment of human capital in that industry. If the industry takes a downturn, you could lose your job and a significant portion of your life savings. Watch out for that.