Financial planning doesn’t have to be hard and it doesn’t have to be complicated. I know that sometimes it can feel overwhelming when you start looking at insurance plans, paying off student loans, and deciding on how to invest your 401k. I remember the first time that I had to choose which insurance plan to use; I spent the better part of an evening researching plans and felt just as confused at the end of the night as when I started. The good news is that you can live a great life and you can make great financial decisions by following a few simple rules. In fact, all of the financial planning that most young professionals require fits onto a sticky note. Here are the rules.
Get your spending in order.
You have to spend less than you make before you can consider anything else. Credit cards are great and have purposes but you can’t rely upon them. You also need to free up some of your income so that you can put it towards other, better purposes. For some people this means cutting out lattes and for others it means packing a lunch versus going out every day. The point is that you have to find the fat in your spending and cut it out.
One of the easiest ways to do this is by using an app to track your spending. You Need A Budget or Mint are two of my favorites; they sync with your bank account and track your spending in real time. They also allow you to categorize your spending so you can see exactly how much you’re spending per month on gas, shopping, food, or whichever category you specify. Finally, they allow you to set specific limits per category and then they remind you when you’re near your spending limit.
For most people, a budgeting app is sufficient. Others might have a bigger issue with
spending. If an app isn’t enough impetus for you to change your spending habits, have no fear. The easiest way to get your spending under control is to start using only cash. Once you’ve set a budget, take the amount of cash out of your account to cover your monthly spending, or two weeks, depending on your pay periods. Take the money and put it into envelopes which are labelled with their specific purpose. The thought behind this is that when there isn’t any money left in the envelope, you’re done spending on that category. It’s pretty self-explanatory. After a few months of this you should be able to better control your spending, so at that point you can go back to using a card and just watching your spending normally.
Build up an emergency fund.
Once you have your spending under control, the next step is to build an emergency fund. We’ve all had unexpected expenses that have come from left field; in the last few months I’ve had to spend several hundred dollars on vet bills for my dog and to buy a new set of tires. All in, I probably spent around a thousand dollars for which I hadn’t budgeted. I’ll be honest and say that I don’t have an extra thousand dollars per paycheck just sitting in my bank account. Instead I had to take that money from my emergency fund. Emergency funds are there to cover any large, unexpected expense. It’s not money for a new couch, pair of shoes, or a car; it’s for things that are required. It’s for hospital bills, fixing the A/C when it goes out in August, or for repairs on the car so that you can go to work.
Another use of the emergency fund is to cover your expenses when you’re in between jobs. While it’s always advisable to have your next job lined up prior to leaving your old job, it doesn’t always happen that way. Sometimes you have to take some time off in between jobs. An emergency fund gives you the flexibility to pay your bills during the interim without having to worry. In fact, a good rule of thumb is to keep an emergency fund of three to six months’ worth of expenses. This doesn’t mean that you make $5,000 per month so you have to keep $30,000 sitting in the bank. Instead, it means that you should have enough to cover your actual expenses, i.e. your rent, utilities, car payments, and insurance, plus enough money so that you can eat.
You need insurance. I can’t stress this one enough. It’s easy to feel like nothing bad can happen when you’re young but the sad truth is that none of us are invincible. I’m in my late twenties and I’ve already lost half a dozen friends and acquaintances. You need to protect yourself by obtaining both medical and life insurance. Medical insurance will ensure that you have access to the medical care that you need in case of illness or injury. Hopefully it will also keep you from a financial catastrophe in the event of a large medical issue. Life insurance doesn’t do much for you, but it protects those that you love in the case of your untimely passing.
You can get medical insurance in a couple of ways. The first, and simplest, is to just stay on your parents’ healthcare plan. If you’re under 26 then this can be a great option, especially if you’re still in school. If you’re on your own then you have two options. The first is to work for an employer who provides insurance coverage. This is generally the cheapest option because most employers subsidize a portion of the cost of insurance. If you have the ability to get employer provided healthcare, do it. The final option is to buy coverage on your own. In the past this was possible but generally prohibitively expensive. With the advent of the Affordable Care Act the healthcare marketplace has expanded and it’s now easier than ever to purchase healthcare insurance. If you’re low income, then you’ll probably qualify for a rebate as well.
After health insurance comes life insurance. You might be thinking I’m young and single, why do I need life insurance? There are two main reasons for young, single professionals to carry life insurance. The first is because funerals are expensive and you don’t want to put that cost on your family. The average cost of a funeral is around $10,000 these days; you don’t want to put that expense on your family, they’ll already have enough on their minds. The second reason is because you probably have some sort of debt that will need to be paid. Student loans come to mind first; if you have a cosigner then they’re most likely on the hook for your loans in the event of your passing. You want to have enough insurance to cover all of your debts, be they student loans, a mortgage, or a car loan.
There are several different types of insurance, but you don’t need to know all of them. All you need to know is that you want term life insurance because it gives you the best bang for your buck. You don’t need whole life, variable life, or universal life. Some unscrupulous insurance agents try to push whole life insurance on young professionals, calling it an investment, but just know that anything other than term life insurance is going to be much more expensive than what you need.
Save for retirement in the most efficient way possible.
Saving in an efficient way means two things; first is that you need to save in a tax advantaged retirement account. Second, if your employer offers a matching contribution to your retirement account, you really need to take it. I don’t know how many times my friends have told me that they just don’t have the money to contribute to their company’s 401k, even though their retirement plan offers a 4% match. Whenever I hear this, I tell them that they’re idiots and they’re literally leaving free money on the table. You need to always contribute enough to your employer’s retirement account to get the match.
When talking about a tax advantaged retirement account, I’m talking about either an employer sponsored plan such as a 401k, SIMPLE, SEP IRA or an individual retirement account, IRA. All of these accounts offer tax deferred (or tax free) growth on your contributions. For young professionals the best option is usually to contribute enough to their employer’s plan to get the full match and then make a contribution to a Roth IRA as well. This allows them to get as much pay from their employer as possible while still taking advantage of the tax-free growth of a Roth IRA. As a refresher, contributions to Roth IRA’s are taxed on the way in but qualified withdrawals are tax free. This means that you get the benefit of compound growth, tax-free. This is a pretty great deal when you’re young and in a low tax bracket. You’re essentially pre-paying taxes now, at a low tax bracket, versus paying later on when you’re older and making more money. It’s a win-win situation.
All of these are pretty simple suggestions but if you follow them, you’ll build a solid financial foundation for the rest of your life.