Summer job? What to do with initial earnings.
For those nearing the home stretch of their summer job, you are likely looking forward to heading back to school or at least ending the extra working hours. Others may continue the job part-time into the school year. I have some tips on what to do with your earnings - after you have a little fun – and how to get more of your earnings sooner, rather than waiting until next spring after tax filing.
Complete W-4 to reflect your tax situation
Everyone completes a W-4 tax withholding form when they start a job. It’s a short form and the check boxes look innocent enough, but this controls what your employer withholds in federal and state taxes. While filing the tax returns next spring, you find out if the withholding was too much or too little - and proceed to pay or receive (slowly) the difference.
For many younger part-time workers, gross income is typically below $12,000 and for federal taxes they owe nothing due to the standard deduction. You will have to pay FICA of 7.65% and typically state taxes if applicable. If you didn’t have to pay any federal taxes last year AND don’t expect to pay any this year, you can write “EXEMPT” below 4.c. on the W-4 form and not have any federal taxes withheld. This allows some extra fun spending money while working.
Now let’s talk savings.
Estimate known costs for next year and put in savings/checking
Before you expose your hard-earned dollars to the markets, first estimate the likely expenses to be covered over the next year (before the next summer job). Since the time horizon is short and the amount is roughly known, set this amount aside in your savings or checking account. Yes, you won’t be earning much interest but the objective is safety and liquidity when the bills are due.
Use remainder for double-duty – reserve fund and tax-free growth
Think of this as working two-shifts simultaneously and getting the resulting financial benefits. The concept is to deposit your longer-term savings into a Roth IRA but earmark a portion for the unlikely but possible event of needing funds quickly and unexpectedly. This portion can be invested in a safer investment in case you need to tap the funds while the remainder can be invested more aggressively.
The key reason this works is one is allowed to withdraw direct contributions to a Roth IRA at any time without a 10% early withdrawal penalty. And because you paid taxes on the contribution going in, taxes are never due on money coming out of a Roth. NOTE – this does not apply to investment earnings until age 59.5 or funds converted to a Roth in the first five years.
A Roth should be considered long-term savings and not used for known expenses coming up, but it works well for a reserve fund while just getting started. You will likely not need to tap all the reserve fund and you were able to get these funds inside the tax-free growth wrapper.
Final note. The maximum amount you can put into an IRA for those under age 50 is $6,000 or your gross earnings for the year, whichever is smaller.
Open Roth IRA at brokerage and deposit contribution
If you like this concept, you need to open a Roth IRA account at your favorite institution. A few firms to consider are Interactive Brokers, Charles Schwab, Fidelity and Vanguard. I did not mention TD Ameritrade because they are merging with Schwab. I also did not mention the popular Robinhood platform because they currently don’t allow IRA accounts.
Opening the account is similar to other accounts you’ve opened. Just check the Roth IRA box. One difference is a concept called ‘Beneficiary’. This is the person who will receive the Roth IRA proceeds when you pass. You can always change this later but the ‘easy button’ now would be a parent. You could also list a sibling, or a couple people with %’s, but I would keep it simple and ideally only individuals over age 17.
While setting up the account, link your bank account to the Roth IRA so you can transfer in your Roth IRA contribution (max of $6k or gross earnings). You could also mail a paper check but you will hopefully be doing this each year so set up the pipes now!
Invest the funds in Roth IRA
You now have cash sitting in the Roth IRA. It will be swept to a money market fund but you now need to invest. NOTE, I will mention a couple tickers here as examples only and not investment advice to help you do get started on your own due diligence. I also would consider using exchange-traded-funds (ETF’s) which trade like stocks but give you efficient diversification. I would not consider individual stocks for this purpose as you are establishing the retirement foundation for the long-term.
First recall a portion of this money is serving as your reserve fund. That portion should be invested in a safer ETF (still can fall in price, but not as much as equities). Then if an unexpected need arises – not the known items covered by the amount in savings/checking – you can sell this quickly and withdraw the funds (up to direct contribution amount). You don’t want the position in a big loss when you need it.
The remaining portion can be invested more aggressively based on your tolerance. Time is on your side so let the markets do the heavy lifting. Compounding returns is your friend!
Here are some tickers that may be appropriate but again, do your own research and decisions. I show two different ETF firms. Also note you can purchase these regardless of where you set up the Roth IRA (assuming at brokerage firm). You don’t need to set up an account at Vanguard to buy Vanguard funds for example.
Reserve fund considerations:
VCSH - Vanguard Short-Term Corporate Bond
SPSB - SPDR Portfolio Short Term Corporate Bond
Long-term considerations:
VT - Vanguard Total World Stock Index Fund
ACWD - SPDR MSCI ACWI
Keep doing it
This is not a one-and-done. Each year you can keep adding to the Roth IRA (up to the maximums, provided you have taxable wages). If you are comfortable with the reserve fund amount initially established, additional contributions can all be added to long-term holding. If you establish a more traditional reserve fund elsewhere later, you can sell the short-term ETF and invest all long-term. There are no capital gains taxes to worry about in an IRA.
Good luck as you head back to school or keep working at the job. You have a long runway ahead – go full throttle!
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