I was fortunate enough to become debt free at a relatively young age. My last loan was paid in full shortly after my 26th birthday. Now if you are really smart and maybe a little bit lucky too, you never had the ‘opportunity’ to borrow any money. In that case good for you because you will be that much farther ahead of the game. The following few lines are going to be about what to do with your money if you are young, single and out of debt.
There are a lot of negative things you can say about carrying debt. But one of the advantages so to speak, is that it gives you a very clear indication of what you have to do (all the way down to two decimal places). It’s a very precise goal. In fact, it also makes giving advice a lot easier too. When I’m talking to a friend or co-worker about finances and I hear about a student loan, or a credit card balance lingering in their lives I know that all I have to say is stop everything that you are doing in your life and pay that sucker off! By saying that, I know with great confidence that I will have given that person pretty solid advice. However, doing the right things with your money after you have paid off all your loans isn’t as clear cut as “work, make payment, repeat.”
If you have had to spend a significant amount of time working down a burdensome amount of debt you have a unique opportunity to parlay that discipline into a fairly wealthy future. If you have never borrowed money then, hopefully, you are already disciplined enough to resist the aggressive marketing campaigns of the various financial products out there. In either case here are some of the things I do and recommend you do with your surplus cash.
While there can be no thing more exciting than free cash flow at a young and irresponsible age it is essential to first set up aside some money for unexpected events. One of the things that defines our youthful generation is mobility and that is the primary reason I advocate for an emergency fund for the young. You just never know when you might pick up and move to Berlin or just feel so disconnected from work that you need to hit the reset button. I have about $6,500 set aside for such peace of mind purposes which is about 3.5 months of expenses and I call this my emergency fund. If I were married, had kids or were a little bit older I would probably want to have a bit more than this saved up but as it turns out I’m not married, have no kids and haven’t started having back pains yet (sorry dad). Therefore I’m pretty confident a can get back on my feet in the face of a short-term emergency with this amount.
Emergency fund allocations ($6,500): Having $6,500 add up to about 3.5 months of expenses translates to about $1,850 in monthly spending. This is super doable for any single debt free 20 something out there. I spread this between my checking account for immediate access, some cash kept in a safe place in case I can’t get to the bank for whatever reason, and a savings account to earn a bit of interest while still having easy access.
If you make $30,000 a year and spend $1,850 a month you can have your emergency fund done in about a year.
Once you are done emergency saving it’s time to start building your financial assets. The first place you want to do this is as far away from taxes as you can. the special accounts you want to consider in this case are IRAs, Roth IRAs (or the work place equivalent 401ks) and HSAs (Health Savings Accounts)
IRAs/Roth IRAs and 401ks: anything you put in is tax-deductible (up to $5500 for IRAs and $18,000 for 401ks for 2016). Take full advantage of these. You will only be taxed on the money you take out of these accounts when you are eligible to do so at about 60 years old. The advantage is the yearly tax deduction, of course, but also the tax-free earnings you enjoy along the way. This means that you get to apply compound interest to a bigger balance than if you had to pay taxes on your investment earnings every year.
A Roth account works in a similar way but you get no tax deduction for what you put in. Instead everything you earn in a Roth account is tax free, even when you withdraw your money in retirement. The maximum contribution for 2016 is $5,500 between a traditional IRA and a Roth IRA (not each).
There are advantages and disadvantages to each form of retirement account (Roth or Traditional) mentioned here and there isn’t always a clear-cut answer to which is best. It all depends on current versus projected tax situations. I’ve decided to hedge between both types of accounts since I can’t say exactly where I or the tax code will be in 30+ years. If you have a 401k plan at work make sure you are eligible for a separate IRA as there are some income restraints.
HSAs: Health Savings Accounts. This is a must for anyone in their 20’s. In order to qualify for this one you must have a HDHP “aka” a high deductible health plan. Make sure your plan meets HDHP requirements before funding a HSA to avoid over-contribution/tax headaches. For 2016 the minimum deductible is $1,350 and the maximum out-of-pocket cost for the plan is $6,550. Both of these requirements must be met to qualify for a HSA. If you have a plan that qualifies you can open a HSA account with a provider of your choice (I use Bank of America but there are many other options out there).
Unless you have a major health concern you have no reason to have a low deductible plan at such a young age. Take the high deductible plan and get the best of both worlds: tax deductions of any deposits (up to $3,350 in 2016. $3,400 in 2017) and no taxes on earnings you make inside the account, same as a traditional IRA. However, you can withdraw any amount out tax-free at any time as long as it is used for medical expenses. But the real advantage to this type of account is just as another retirement account. If you can manage to keep your money in a HSA until age 65 you can withdraw your money for any reason and not pay a tax penalty. You would treat your withdrawal as part of your earnings and just pay normal income taxes on it. With an HSA you get the benefits of tax deductions, tax deferrals, peace of mind (you can use it tax-free/no penalty on medical emergencies) and as potential retirement income.
Bottom line: In order to max out an IRA and HSA all you need to do is have $5,500 + $3,350 = $8,850 available above your net expenses. If you spend $1,850 per month that means your yearly spending is $22,200 add that to $8,850 and you can do all this with just a $31,500 net income per year! You have to admit this is completely doable and maintainable over your working life if you combine hard work with good frugal practices. If you make more than $31,500 per year (also super doable in America) You can do many more things above and beyond these basic tools of personal finance. But these should definitely come first.
Fully funding a 401k would require a bit more income as the max contribution per year is currently $18,000 but if your work offers such a plan you should aim to max it out. if your salary can’t get you there alone try to work on other sources of income to live off of while you use your salary to max out the retirement account. As your income rises throughout your life maxing out all the tax advantaged accounts out there will already be second nature to you. At that point if you want to continue setting money aside your next destination will be taxable accounts. Having to invest in regular taxable accounts shouldn’t be a bad thing though because it means that you have a high enough income to do so. Congrats!
Next level reading: http://www.madfientist.com/front-loading/
This is a cool article thinking about the effects of front loading your retirement accounts meaning you max out all your retirement accounts at the beginning of the year.