Financial Planning: What You Should Know When First Getting Started
The idea of financial planning can be overwhelming, especially when you’re first getting started. You may be in your first job, or just beginning to really start thinking about saving for retirement or investing. At this phase, the choices available for savings and investments often look like a bewildering alphabet soup of 401(k), IRA and HSA, and many people with the right intentions are left on the sidelines scratching their heads.
Well, relax. No one knows it all at the beginning. In fact, the first step is simply establishing awareness of what you need to know. Finances are all about handling your money so you can plan for the life you want, whether it’s extensive world travel or raising a big family in a nice home. It can be difficult to reach those goals if you don’t understand the choices and options that can help you get there.
Establishing a Budget
Establishing a budget is a crucial foundation for your finances. When your income and expenses are the same every month, it’s easier to plan. If your expenses are greater than your income, you’re living beyond your means. You might be going into debt, which can hamper your cash flow for the future and make it impossible to save.
“Budget” in this context just means keeping tabs of your monthly income versus expenses by category. If you’re overspending, take a look at your spending and find ways to reduce what’s going out of your pocket. If you have excess cash every month, you can start putting this money to work to fund your future goals.
Americans collectively owe almost $14 trillion in total household debt, so if you owe on credit cards, student loans or other forms of debt, you’re not alone. But part of optimizing your financial life is managing your debt, because minimizing debt means you can further maximize your contributions to other assets.
The standard definition of assets is “anything of value that can be converted into cash” as well as cash itself, of course. If you have a checking account and a car, you have assets. Other forms of assets include stocks, bonds, Certificates of Deposit (CDs), houses, retirement funds and anything else of significant value, such as collectibles or jewelry.
It’s important to keep tabs on your assets just as you do your income. Once you begin an investment portfolio (stocks, bonds and other cash instruments), it’s important to maintain an asset allocation specific to your goals that will allow for growth, while also providing some protection against market risk.
The performance of your assets, compared to your goals and tolerance for risk, should be monitored regularly to make sure the allocation is in alignment.
Retirement savings are usually an important category of asset accumulation. For most people, Social Security benefits will not be enough to retire on. The earlier you start saving in retirement vehicles, the more your savings have time to appreciate.
There are two major types of retirement savings vehicles: 401(k)s and Individual Retirement Accounts (IRAs). Let’s take a look at each one.
A 401(k) plan is a tax-advantaged plan offered by employers. Generally, you choose a percentage of your income to contribute.
A 401(k) plan has several important advantages.
First, the percentage you contribute is deducted from your paycheck before tax is taken out, which can result in a considerable tax savings not only on that money but potentially on your overall salary. Your gross income available for taxation is reduced.
Second, your contributions grow tax-free until you withdraw the funds.
Third, many employers offer matching 401(k) plans, which means your employer will match the percentage you’re contributing by a certain amount. Say you make $40,000 per year and you elect to save 5 percent, or $2,000 per year. If your company offers a 50 percent match, they will contribute an additional 50 percent, or $1,000, every year. If your company offers a matching 401(k), not participating might mean leaving money on the table.
The maximum 401(k) contribution per year is $19,500 for 2020, far higher than other retirement plans.
A 401k for Millennials can be especially beneficial because the younger you are, the more time it has to work for you.
IRAs are individual retirement accounts. Two common types are Traditional IRAs and Roth IRAs. Both are tax-advantaged, but the advantages manifest at different points in your life.
Your contributions to a Traditional IRA can be deducted from your taxes every year, subject to certain income limitations. Contributions you make to both appreciate tax-deferred until you withdraw them.
Contributions to a Roth IRA cannot be deducted, but when you withdraw Roth IRA funds in retirement, you won’t be taxed on the amount.
For 2020, the maximum IRA contribution for either type of IRA is $6,000.
Health Savings Account
A Health Savings Account (HSA) is a type of tax-advantaged savings account intended to be used for healthcare spending. Like 401(k)s, many are offered by employers and contributions are made pre-tax, which can lower your annual gross income. (You can also open them yourself.)
Funds that you withdraw for qualified medical expenses are not taxed. They are portable (you can take them with you if you change employers) and you can roll over any unused amount every year.
To participate, though, you must be enrolled in a high-deductible health insurance plan. HSAs are complex, so be sure to read all the fine print.
How an Advisor Can Help
As you can see, financial planning can be exciting but also complicated. Talking with a financial advisor can be a smart move. A financial advisor can help you plan strategically and help ensure you don’t miss something that could help you reach your goals sooner.