5 Crucial Steps Every Young Adult Must Take to Achieve Financial Independence
Achieving financial independence is an elusive goal for most people, but it can be an especially slippery proposition for young adults today. The general economic environment is as challenging as ever. At the same time, the media-driven imperatives to spend, consume, and live a money-defined version of "social success" are more intense than ever.
To help you get through this difficult passage of life, here's some financial advice from someone who has been where you are. Here are five financial tips to help you manage your money and achieve financial independence:
1. Pay down credit card debt
Focus on controlling credit card debt because it's more expensive than virtually all other types, including student loans. The interest rates on a graduate’s Stafford Loan runs about 6.8 percent while credit cards run double and triple that amount. Pay down credit accounts and aim at maintaining a maximum 30 percent credit utilization ratio. In other words, keep your card balances at 30 percent of the total credit limit. If your total credit line is $10,000, owe no more than $3,000 (and spread the same ratio over multiple accounts).
2. Establish emergency savings
Creating an emergency fund to cover several months worth of living expenses can help you manage the unexpected crises and misfortunes we all face. Those in more volatile careers -- employees of start-ups, for example -- should look to save even more. That money can then be used for things like job transitions, starting your own business, or training for new skills to increase your professional potential.
A common rule of thumb is to save 15 percent of your annual income in your 20s, with 5 percent going into your emergency fund and 10 percent to long-term savings. As you age, increase the percentage of income you're saving, to 20 percent in your 30s, and even more in your 40s. Find out how much money you might end up saving over time with a savings rates calculator.
3. Start early with long-term savings
Even though you may be years away from retirement, the best thing you can do to eventually retire happily is to understand compound interest. Quick calculations reveal how the compounding of earnings in a retirement account can increase exponentially in your retirement savings. If, for example, you start saving today $100 per month over a 40-year period, which compounds monthly at a 5 percent rate of return, your $48,000 contribution ($100 per month for 480 months) will have grown to approximately $152,602. If, instead, you wait 10 years to start saving, you would have to contribute approximately $66,010 over a 30-year period ($183.36 per month for 360 months) in order for your savings to grow the same amount. And you would have to contribute approximately $89,105 over a 20-year period ($371.27 per month for 240 months) to do it.
4. Maximize employer-provided benefits
Probably the best investment vehicle available to you is your employer's 401(k) savings plan. If it’s offered to you, take full advantage. Contribute as much as the non-taxable limits allow, if possible, but certainly enough to qualify for the company's matching funds.
In the most common 401(k) plans, employers will kick-in $0.50 for every $1 you contribute up to 6 percent of your income. These employer-match contributions are free money. Taxes on the combined contributions and their earnings are deferred until they are withdrawn, presumably after retirement when you will need less income and enjoy a lower tax bracket.
What's more, every dollar you manage to set aside for saving ends up limiting your consumption by a dollar. The less income you spend for consumption now means the less income you'll have to replace after retirement -- something of a bonus savings from savings.
Another advantage to 401(k) plans -- they allow participants to float a loan from their contributions in an emergency. Be careful if you change jobs, though. The loan is due immediately and failure to repay means payment of the taxes plus a 10 percent surcharge.
If you can contribute more to savings, fund a Roth IRA. Roth IRA withdrawals are tax-free after the age of 59.5 on accounts more than five years old.
Also, be sure to fund your health savings account provided at work to the maximum. You can fully fund an HSA account and the money compounds tax free. HSAs can also yield cash for emergencies. Tax-free HSA withdrawals can be made retroactively. So if you've spent, say, $2,000 out of pocket for a decade on medical expenses, you can later claim the $20,000 in unreimbursed medical expenses (maintain records and save receipts).
5. Actively invest and manage your savings
Allow your long-term retirement savings to accumulate and grow. In most 401(k) plans, investments are managed through the provider. The younger you are the more active you want to be about investing. But keep in mind the risks involved (risk-taking should diminish with age). Also, don't forget to diversify. Half your investments should be in quality large-cap growth and value stocks, another 30 percent spread among small and mid caps, and 20 percent in international stocks.
Invest as economically as you can by using exchange-traded funds (ETFs) when possible. They’re cheaper and easier to trade than traditional mutual funds. Their management tend to be more passive as they buy large pools of stocks from a specific index (which calls for active management by the investor).
Also pay close attention to the expense ratios listed in prospectuses. For example, a typical ETF’s expenses are 0.09 percent while a mutual fund may charge 1.3 percent. Obviously, after 35 years of these fees compounding, the ETF investor would likely be ahead by a third over the mutual fund investor.
If you're confused about investing, don't worry. You're not alone. It might benefit you to seek the advice of professionals, but always be sure to manage your own investments so you understand exactly what's happening with your money. It's your future. Also, don't be afraid to make mistakes. Sometimes the best way to learn is by making mistakes.
The reward is financial independence
Young people who follow these steps over time -- and develop the necessary disciplines involved -- can achieve the peace of mind that comes with financial independence.