No “Dad Jokes”, Just “Dad Financial Questions”
To the recent college graduates – Congratulations! Your last semester didn’t go as planned in these unique times but an exciting future still lies ahead. Some of the topics in that future will be financial related. In this blog post I share some general financial advice for those early (or not so early) in their career in a Q & A format.
Q1. What does “Big hat, no cattle.” mean?
A1. Avoid it by living within your means. It is an expression from ‘Millionaire Next Door’ describing people who appear wealthy given their lifestyle but have very little savings.
Of all the things listed, this is probably the most important and applies all through life. Getting the first career paycheck is exciting and likely a nice increase from past jobs. It can be tempting to go out and get all those nice things your parents or other adults have – luxury apartment, lavish furnishings, new car and other things. Yes, you can likely step things up a bit, but don’t overdo it relative to your income.
Q2. My salary is $50,000 per year. Why isn’t my monthly paycheck $4,167?
A2. Employer withholds three types of tax on your behalf, deducts insurance premiums and directs 401k savings.
It is important to understand your paycheck and concepts like gross vs. net income, taxes (Federal, State and FICA), health premium and other insurance deductions and the impact of a Traditional vs. Roth 401k on taxes. Here is an example assuming a $50,000 gross income for an Illinois resident (state taxes vary; some have 0%). I show the difference between using a Traditional vs. Roth 401k here but I will reference those details later. For now, note that a Roth contribution is not tax deductible and results in a slightly lower net paycheck. However, no further taxes are due on that amount including investment growth which can be a very good thing if currently in a low tax bracket.
|If use the following 401k:
|Social Security +Medicare Tax
|<= 7.65% FICA
|Traditional 401k Savings (6%)
|<= 6% of Gross; before Fed, state tax
|<= estimate after standard deduction
|<= estimate for IL; some states 0%
|Roth 401k Savings
|<= 6% of Gross; after Fed. state tax
|Net Income after savings
|Health Insurance Premium
|<= vary by age and employer
|Disability Insurance Premium
|<= highly recommend
|Net Take-Home Pay
|<= net paycheck
Q3. What is a budget and how would it help me?
A3. See where gross (not net) salary goes between savings, taxes and major expense categories. You have to measure to manage.
After understanding the deductions of a paycheck, you may wonder if the net take-home pay will cover other expenses and maybe increase savings. The best tool to answer that is a budget. I refer to it as a “savings generator” since you likely will find some discretionary items that can be directed towards other priorities or savings. A simple spreadsheet (or pen and paper) can account for the major categories. Once the budget is established to use as guideline, there are convenient tools to track actual spending by category. Here is a high-level example (everyone has different category priorities). Be sure to start with gross income and account for taxes, savings and insurance deductions from the paycheck. I intentionally put ‘Savings’ before expenses to ‘pay yourself first’. As a wise elder would impart whenever he got the chance “save your money”.
Q4. I’ve never done this before. What does the average person spend on these categories?
A4. Have savings and spending match your priorities. But as a reference, here is a summary from the BLS.
Each person has their priorities of where hard-earned dollars go. To compare to the average consumer, reference the “Consumer Expenditures” report from the US Bureau of Labor Statistics (BLS). The most recent report from May 2020 summarizes data gathered through 2018 and shows % of income spent by major categories (see graph below). Note this is for all ages and income levels. To see a detailed report for 25-34 year-olds, further broken out by the 4 major regions in the US, see this table. The categories in this table are much more refined but focusing on the first and second level breakout will get what you need. Note that part of savings is captured in “Personal Insurance and pensions” and includes Social Security taxes paid.
Q5. What happens if I have an unexpected large expense not budgeted?
A5. You need a reserve fund.
It may seem at this point in life you won’t have a need for a fund to cover unexpected expenses – job loss (just hired), leaky roof (I don’t own), car breaks down (Uber). But you will have a need for unexpected cash outlays larger than the monthly budget. A credit card may give you some flexibility but you want to get in the habit of paying that off each month. Because of this, don’t put all your extra savings in a 401k or IRA. Establish a savings fund with after-tax dollars to put a safety valve on your finances. See the next section on using tax savings from the 401k for the first year to help kick this off and consider using a Roth IRA for double-duty - both tax-advantaged savings and a reserve for unexpected big-ticket items (see Q7).
Q6. My employer offers both a Traditional and Roth 401k/403b. Should I participate? Which one?
A6. Yes, especially if the employer matches part of your contribution. Traditional v. Roth mainly depends on tax brackets.
If your employer offers a 401k and you are eligible (may have to be employed for short while), I strongly encourage you to participate. Not only is this a great vehicle to kick-start your tax-advantaged savings, oftentimes your employer will match part of your contributions up to a limit. Think of this as free money or a 100% return on your investment and should save at least up to that limit. Be aware these funds should be viewed as inaccessible until retirement, though you can get at the funds in certain circumstances.
Another important decision is whether to use a Roth or Traditional. There are many unique factors to consider but don’t let that prevent you from starting – you can always change it later. The key difference is a Traditional 401k gives you the tax deduction up front but must pay taxes when withdraw. The Roth 401k is the opposite. The key driver to decide – what is tax rate now vs. expected when withdraw funds in retirement (see table below). Early in your career you may be in a low tax bracket and a Roth may be optimal. One twist on this is to use a Traditional 401k the first year and direct the tax savings from deduction to help establish a reserve fund (an extra $500/year in my paycheck example at beginning).
Q7. My employer doesn’t offer a 401k/403b. Anything else I can do?
A7. Use an individual IRA. This applies even if you have a 401k/403b.
Everybody, even those with a 401k/403b, can contribute up to $6,000/year into an individual IRA provided they have taxable compensation at least that high. Those 50 and older can add an extra $1,000. If a Traditional IRA is used, contributions are deductible if you don’t have a 401k/403b plan at work. If do have a plan, adjusted gross income must be below $65,000 to be fully deductible. If a Roth IRA is used, adjusted gross income must be below $124,000 to contribute the full amount. Recall there is no deduction for a Roth. A Roth IRA could also be used as a ‘large ticket’ reserve fund since contributions (not earnings) can be withdrawn without penalty or tax. Only use in a true emergency but this is a way to begin funding a Roth sooner.
Q8. My employer also offers a medical plan with a Health Savings Account. Should I consider that?
A8. Definitely look into that type of plan.
For health insurance, I encourage you to look at the different options and trade-offs of premium costs (both you and employer) and potential out-of-pocket costs. A key driver to the premium/cost trade-off is driven by the deductible – the amount you pay for unexpected health costs (most routine preventative check-ups are covered) before insurance kicks in. Hint – higher deductibles lead to lower fixed-cost premiums and since the first $xx dollars is on your dime, it encourages you to think twice about running to the doctor for the sniffles. This extra savings is passed to you in the form of lower premiums and less out-of-pocket costs. If you have a qualified high-deductible plan (check with employer) you can open a Health Savings Account, contribute up to $3,550, get full tax deduction, and it grows tax-free and even comes out tax-free if used for qualified health expenses.
Q9. Do I need to prepare a balance sheet when my assets are low?
A9. Yes. And don’t forget your current most valuable asset – future earning power.
A balance sheet simply lists your assets on one side and liabilities (loans and credit cards) on the other. The difference between the two is your financial net worth. Early in a career the investment assets may be low but don’t forget to consider future earning power and be sure to protect it through insurance (disability insurance for all, life insurance if others depend on you financially) and investing in self (professional reading, conferences, classes, podcasts – 2x!). If you want to begin saving for major expense (house, grad school, vehicle) begin saving additional funds outside the 401k and invest in safer assets since the funds will be needed over the next few years and shouldn’t expose a large portion to equities.
Q10. I can't do all these savings, pay off my student loans and still have fun. What are the priorities?
A10. There will be limited resources (money, time, demands) and it is critical to recognize and prioritize.
Regarding the money resource, here is a framework to consider. I am assuming the amortized monthly amount of student loan debt is part of your budget, student loans are part of DIRECT program and not high rates, you have excess savings to prioritize and are an aggressive to moderate aggressive investor.
- 401k/403b up to maximum employer match; brown-bag it if you have to
- pay off credit cards in full each month; you are borrowing against future income at high rates
- build up about 1 month worth of non-discretionary expenses in bank account
- Individual Roth IRA (tax advantaged savings + big-ticket reserve fund)
- Health Savings Account if available; after first year do this before Roth IRA
- Back to the 401k/403b up to maximum $19,500/year
- Compare adding additional taxable savings or paying off additional amount to student loans (note student loan interest is deductible if AGI under $85,000; a 5.00% loan rate drops to an after-tax-deductible 4.15% if 12% Fed and IL resident)
After you get settled into a job, other financial related topics will arise down the road. Additional savings goals for graduate school or a condo/home purchase will impact how you save and borrow. Rather than overwhelming you with more details, I will stop here and let you focus on getting started. If this feels overwhelming, seek help to begin tax-advantaged savings. But don’t lose sight of your goals and dreams, keep things in context… and stay curious.
Posted by Kirk, a fee-only financial advisor who looks at your complete financial picture through the lens of a multi-disciplined, credentialed professional. www.pvwealthmgt.com