How to Start Building a Solid Financial Foundation
As a young adult, it can be difficult to know how to start building a solid financial future. With all the responsibilities of starting a new career, paying bills, finding housing, navigating a new city, etc., you may be tempted to put financial planning on the backburner. However, the sooner you start planning for your financial future, the better off you’ll be in the long run. The following tips can help you get started.
Tip #1 – Create a budget.
Begin by identifying how much money you spend each month, and compare that amount to your monthly income. There are several ways to do this, all of which consider two types of expenses: fixed and discretionary.
Fixed expenses are those you must pay each month. Examples include:
• Minimum credit card payments
• Car payments
• Utility bills
• Cell phone
Discretionary expenses are costs you choose to take on that may not be essential for living your life. Examples include:
• Eating out
• Movie and concert tickets
• Streaming TV subscriptions
Once you’ve added up all your fixed and discretionary expenses, compare the total to the amount of income you bring in each month. If you’re spending less than you bring in each month, congratulations! You’re one step closer to a stronger financial foundation. On the other hand, if you find you’re consistently spending more than you’re earning, you may need to trim some of your discretionary expenses to bring you back to level footing.
Begin by looking at the discretionary expenses list. Where can you lower your spending? Maybe you can cut back from eating out four times per week to one or two times per week. Perhaps you don’t need all your streaming services. Or maybe you choose to take your next vacation closer to home rather than paying for a plane ticket.
The key here is to establish a budget that allows you to pay your fixed expenses and certain valued discretionary expenses while living within your means and taking care of any obligations you may have.
Tip #2 – Pay off debt.
Regardless of the type of debt you carry (student loan, credit card, auto loan, etc.), the sooner you pay it off, the sooner you’ll be able to achieve financial security. While there are times when it’s necessary to take on debt (such as student loans to pay for higher education or a mortgage to pay for a home purchase), there are other times where outstanding debts, if left unmanaged, can spiral out of control.
Two effective strategies for paying off debt include:
The snowball method – This method involves paying off your smallest debt balance as quickly as possible, then moving on to the next-smallest debt. The benefit of this approach is it can help you gain a sense of accomplishment as you knock out one loan after another.
The avalanche method – Using this method, you begin paying on whatever loan has the highest interest rate. Once that is paid off, you move on to the loan with the next-highest interest rate until all loans are paid off. This approach allows you to pick up speed as your go because each payment saves you more money than the one before.
Tip #3 – Build an emergency fund.
If an unexpected emergency arises, you’ll want to ensure you have funds available to handle whatever may come your way. An emergency savings account can enable you to keep up on your necessary expenses, pay down debt and continue your lifestyle for a short period of time. A great rule of thumb is to have three to six months’ worth of living expenses saved in this account. Having an emergency fund established can protect you from taking on additional debts to meet your needs, which is important to avoid — especially if you’ve done the work to eliminate outstanding balances!
Tip #4 – Save for retirement (also known as financial independence).
While retirement (and financial independence) may seem like a long way off, the sooner you start saving, the better your chances will be of achieving or maintaining the lifestyle you want. The easiest way to get started is by contributing to your employer-sponsored retirement plan at a rate that maximizes your employer matching contributions while still being sustainable over time.
Don’t have access to an employer-sponsored plan? Consider opening an individual retirement account (IRA). There are two main types of IRAs: traditional and Roth.
Traditional IRA –Contributions are made on a pre-tax basis, which reduces your taxable income in the year you contribute. Money invested in a traditional IRA is free to grow tax-deferred until retirement. Distributions from the account are taxed as ordinary income in retirement and may be subject to a 10% early withdrawal penalty if taken before reaching age 59 ½.
Roth IRA – Contributions are made with after-tax funds, providing no tax benefits during the year in which you contribute. However, contributions can be withdrawn after five years with no taxes or penalties (earnings are subject to tax and a potential 10% penalty if withdrawn before you reach age 59 ½).
If you’re just starting out in your career and expect your income to rise over time, consider contributing to a Roth IRA before income limits restrict your ability to do so. On the other hand, if you have high taxable income, you may want to consider contributing pre-tax funds to a traditional IRA to lower you tax liabilities in the current year.
Tip #5 – Avoid lifestyle inflation.
Inevitably, as your income increases over time, it may be tempting to increase your spending as well. This tendency is sometimes referred to as “lifestyle creep,” and if not carefully managed, it can get in the way of your long-term financial goals. When your income increases, consider increasing your savings first rather than increasing your spending to match your income.
Could you use some help planning for your financial future? Creative Planning is here for you. Our experienced professionals help clients navigate all aspects of their financial lives in order to achieve their long-term goals.
This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
How to Start Building a Solid Financial Foundation