3 Smart Money Moves to Make in Your 20s
Financial literacy and money management are important life skills. Unfortunately, most people never study this in school, leaving many young adults ill-prepared to deal with their finances as they enter the work world, often in their early twenties.
When you begin your career, you begin the asset accumulation phase of your financial life. Habits you form now can lay the foundation for successful wealth-building throughout your working years. Here are three important money moves you can make right now.
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1. Save your first $5,000 in an emergency fund
It's non-negotiable that everyone needs an emergency fund -- one that's in an FDIC-insured on-demand account with enough money to cover a large, one-time unexpected expense or a potential job loss. In order to calculate how much emergency savings you currently have, divide your available cash and other liquid assets by your non-discretionary monthly living expenses.Your goal should be to save six months' worth of living costs.
When you are just starting out, saving that much cash can seem quite overwhelming. That's why I like to suggest starting with a smaller yet still substantial goal of saving $5,000 by the time you are 30. That could be enough money to cover a one-time emergency payment for a car repair or help pay a couple months of rent if your income disappears. Ultimately, your emergency fund will be the foundation of your personal financial portfolio.
2. Start saving for retirement
If you have access to an employer-sponsored retirement plan like a 401(k), be sure to enroll in this automatic savings program. For 2017, you can contribute up to $18,000. If your company offers a match, always contribute enough to get the match, which is free money. If you don't have access to a retirement plan at work, then open an IRA at any discount brokerage firm. For 2017, you can contribute up to $5,500 to an IRA.
While a savings rate of 10% is often recommended, I believe in today's environment, with the scarcity of pensions, the uncertainties surrounding Social Security, and our increasing life expectancies, saving about 15% of your gross income is a better bet -- and that includes any employer contributions.
One important reason why you should start saving as early as possible is because of the undeniable impact of compounding. For example, if you save $5,500 a year starting at age 25 in an account earning a 6% return, then you'd have about $900,000 by age 65. However, let's say you don't begin saving until age 35; you'd have about half that amount when you reached age 65. This is a powerful example that illustrates the effect oftime on your investments.
Finally, as you move between jobs throughout your career, take your retirement account with you by rolling it over either into your new company's plan if allowed or to an IRA at a discount brokerage firm. Remember, qualified retirement accounts, like a 401(k) or IRA (up to a certain limit) are shielded from creditors even in bankruptcy, so it's important that you not liquidate these accounts, especially to pay off debt.
3. Limit your consumer debt
Credit cards play an important role in helping us build a credit history and to assist us in an emergency. What they should not do is facilitate a lifestyle that you cannot afford. And while debt is often necessary to achieve goals such as buying a house, consumer debt is non-housing debt that represents items that have been consumed and do not appreciate in value.
In general, there are debt benchmarks that financial professionals use to evaluate an individual's overall financial standing. In particular, the debt-to-income gauges whether you have too much debt and are in jeopardy of being unable to pay your non-discretionary living expenses. To calculate your debt-to-income ratio, divide your monthly non-housing debt payments by your monthly net (or after-tax) income. Aim for this number to be 20% or lower.
For example, if you bring home $2,000, then you don't want more than $400 of your take-home pay going toward paying off debt. And while this is a general guideline, if you are spending more than 20% of your take-home income on servicing debt, you may be at risk of being unable to meet your other financial obligations.
Learning early on to live within or below your means is a fundamental financial lesson, as high debt levels can lead to years of financial hardship, including bankruptcy, lower credit scores and thus higher interest rates on loans, and decreased retirement savings. Forming strong credit habits now can be the bedrock of your financial foundation.
Ultimately, the one component of financial planning that you cannot get more of is time, and your twenties is the perfect time to get started on a path to a lifetime of financial security.
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