Most high schools and colleges don’t teach personal finance in class, and managing money is only getting more complicated.
When Peter Palion, a Certified Financial Planner and founder of Master Plan Advisory, filed his first tax return, it was 10 pages long. When his millennial daughter filed her first tax return, it was 43 pages long. “My daughter is not a commodities trader,” he said. “This was just money that she made while she was in high school, from the type of activities a high school student would engage in.”
Taxes are just one example of the growing complexity of personal finance.
This complexity, combined with the fact that most people never get a formal personal finance education, leaves parents and guardians with the responsibility to teach their kids about money. The issue with that, Palion said, is that many of these people also don’t have a strong handle on saving, investing, and other financial topics. They didn’t learn it in school, either.
Here are three things every new grad should understand about managing their money.
1. The Power of Compounding Returns
When it comes to investing for retirement, you should start as soon as you can — at your first job, if possible. Even if you can only sock away $50 per month in the beginning, it will be worth it.
“The sooner that you start, even with a relatively modest amount of money, you're going to end up with a much higher amount of savings than someone who, let's say, doesn't start until the age of 40,” Palion said.
That’s because of the power of compounding. Compounding is the process by which money grows when investment earnings are added to the total balance of the account.
Here’s an example. Say you start investing for retirement at age 20, and you save $100 per month until age 65. With a return of 6%, you’ll end up with nearly $280,000 in that account. On the other hand, if you start at age 40 and contribute $300 per month toward retirement, you’ll have just under $210,000 saved by age 65.
... money grows when investment earnings are added to the total balance of the account ...
If you start early, you’ll end up with nearly $70,000 more, even though you put $36,000 less of your own money into the account.
The earlier you start, the less you have to actually save, since compounding is making your money grow over time.
2. How to Manage Debt Responsbily
Fifty-five percent of the undergraduate class of 2020 graduated with student loans, according to the College Board. Unlike many in their parents’ and grandparents’ generations, young people are starting off their adult lives saddled with debt.
“You graduate with a student loan, then you need a car, so you end up with a car loan, then a lot of people get in trouble with credit cards,” Palion said.
Credit cards can be a powerful way to build a strong credit profile, which will help you get the best possible rates on mortgages and other loan products. Rewards cards also can get you cash back or travel points on money you would have spent anyway. But they need to be used responsibly — ideally by paying the balance off in full each month to avoid interest.
Palion added that if you don’t manage your debt correctly, getting a favorable mortgage to buy a home can be much more difficult down the line.
That’s because one of the factors mortgage lenders consider is debt-to-income ratio, which is your total monthly debt payments divided by your total monthly income. If yours is higher than 43%, you may have trouble getting approved for a mortgage. And if you are delinquent on your debt payments, then it’ll become even harder.
3. The Information on Your Pay Stub
IIf you don’t understand every line item on your pay stub, you’re not alone. But you should make sure you’re reviewing and understanding it each pay period; more than half of Americans have found an error on their pay stub at some point during their career, according to the Workforce Institute.
Beyond what the various acronyms mean — FICA (Social Security and Medicare tax), SUI (state unemployment insurance), OASDI (old age, survivors, and disability insurance) — you should understand how much is being taken out of your paycheck for taxes.
“If you don't understand, for instance, that you may be under-withholding, then you’re going to owe taxes when you file your tax return,” Palion said.
It’s never fun to get hit with an unexpected bill at tax time. (If you receive a bill you can’t afford to pay, the IRS will work with you on a payment plan, so don’t worry!)
If you’re not sure how to gauge whether your withholding is correct, the IRS has a tool to help you figure it out. Note for the future (or if you’re a grad student or young parent): It’s especially important to check your withholding if you’ve recently gotten married or divorced or had a child, since these factors can influence your tax situation.
You should also check to make sure that you’re not withholding too much from your paycheck for taxes. When you over-withhold, you end up getting a tax refund. While it may feel great when that refund hits your checking account, it’s probably not the best use of your hard-earned money.
Palion described one tax season when his daughter was thrilled to receive a tax refund. He joked, “If you're so happy, why don't you give me a thousand bucks right now? And I'll give it back to you with no interest a year from today.” That’s pretty much what’s happening when you get a tax refund. Over-withholding tax, then receiving a refund when you file your return, is like giving a 0% interest loan to the U.S. government. If you withheld the correct amount instead, you would get more money in each paycheck, which you could save or invest.
Educating Yourself (and Maybe Changing Things for the Next Generation)
There is seemingly infinite information about virtually every topic on the internet, and personal finance is no exception. But Palion said that there’s also a lot of misinformation out there. If you do take to the internet for personal finance advice, look for articles that consult experts like Certified Financial Planners and link to official resources, like the IRS. MyMoney.gov, a U.S. government site affiliated with the The Financial Literacy and Education Commission, can be a great jumping-off point for financial topics ranging from homeownership to starting a business to dealing with the death of a family member.
Palion said he has hope that the current generation of young adults can make personal finance more comprehensible for the future.
“Hopefully, when they grow up and it's time for them to take over from the current generation, they will come up with a better system,” Palion said. “Which would be great for me, because by the time that I'm 80, I'm probably going to be just as lost as today's millennial trying to read instructions for a tax form.”
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