This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
Emergencies come in all shapes and sizes. If you get into a small accident you may need to pay the $500 deductible on your car insurance. Maybe your furnace will need replaced and it will cost $1,500. Perhaps you will get laid off from work and it may take a few months to find a new job. As you can see emergencies are unexpected events that drain our finances. Imagine if you had no money saved and you had to replace your furnace. What are you going to do, use a credit card? Do you really want to get back into that again? Let’s say you lost your job. How are you going to make the credit card payment for your new furnace when you have no income? How will you eat?
Not to sound too dramatic, but you have to save at least $1,000. Everyone should have at least $1,000 in his or her savings account. From there you should build up your emergency fund to cover three to six months worth of expenses. Notice I said expenses, not income. We make more than we spend (hopefully). Also, we spend more than we need. What is three months worth of expenses? Well, rent or mortgage is needed, as well as other payments such as your car and insurance. You will also need to pay for utilities and food. What you do not need to worry about are things like savings, dining out, entertainment, etc. Sure, these things are nice, but you could probably forgo them if you had to.
So now you are contributing to your 401(k) at work, and you are saving money towards your emergency fund. You may be thinking there is not enough money left for anything else. Don’t get too hung up on your emergency fund. If you save just 10% of your money towards an emergency fund, it will take you about two full years just to save three months worth of living expenses. My recommendation is to save the first $1,000, then focus on paying off your debt. After all, your living expenses will be lower if you do not have any debt payments.
Individual Retirement Accounts (IRAs)
After you are more comfortable financially, perhaps once your debt is paid off, you can begin investing on your own. You can invest outside of your 401(k) for your retirement, and you can actually invest just to make money. This is what we mean by making your money work for you. When you invest for retirement purposes, you can shelter your investments from taxes by using an Individual Retirement Account (IRA). An IRA is not an investment of its own, it is a type of investment. An IRA could be a stock investment, a bond investment, a mutual fund, a certificate of deposit (CD), or a few other types of investments. You can choose between a traditional IRA and a Roth IRA.
The Individual IRA allows you to deduct the amount you contribute from your current taxable income. Thus, just like your 401(k), you will not have to “give up” as much money as you contribute from your current income. If you are in the combined 30% state and federal tax bracket, and you contribute $2,000 to your traditional IRA (the current maximum contribution allowed), you will save $600 in taxes this year (30% x $2,000 = $600). Now, it gets even better. Any gains you receive while your IRA is growing are not taxable. That means if your IRA increases from $10,000 to $20,000, you pay nothing. Once you retire and start withdrawing from your IRA is when you pay the taxes. You will be taxed as if the money you are taking out is regular income. In theory, by the time you retire, you will be in a lower tax bracket since you will not be working. That depends on what the current brackets are when you retire and how much money you take out of your IRA each year.
The Roth IRA does not provide immediate tax deferral like the traditional IRA does. In other words, if you are in the 30% tax bracket and you contribute $2,000 (the maximum allowed), you will not save on any current taxes owed. The advantage of the Roth IRA is that you will not pay any taxes on your money when you withdraw it. Also, you will not pay any taxes on the money as your IRA grows (just like the traditional IRA). Basically, you have already been taxed on the money, so you are done paying the government their share.
So which do you choose? There are several factors that determine the best fit for our finances. The IRS has specific rules that govern how much you can earn and still be eligible to contribute. Assuming you do not make too much to be eligible, it really depends on how much money you have. As a rule of thumb, if you cannot afford the whole $2,000 contribution, just stick with the traditional. That way you will either be able to contribute more, since you will save tax dollars, or you will still have spending money left over after you contribute. If you are easily able to maximize your $2,000 contribution, you may want to use the Roth IRA, since you will be able to withdraw more when you retire (since the Roth IRA will not be taxed when you withdraw). Here is an example.
To illustrate this with numbers, let’s assume Matt contributed the maximum to a traditional IRA and Pat contributed the maximum to a Roth IRA. We’ll assume their IRAs were both invested in the same mutual fund, so both of their accounts are worth the same amounts. If Matt withdraws $50,000 at retirement and he is in the 30% tax bracket, he will pay $15,000 in taxes and will only have $35,000 left to spend. If Pat withdraws $50,000 at retirement and she is in the 30% tax bracket, she will pay no taxes and will have the full $50,000 to spend. Again, this only applies assuming you can afford to maximize your contribution; otherwise you might as well use the traditional IRA.
There are special rules to consider with the IRAs. There are severe penalties if you withdraw your money early (before age 55 ½). You will pay a 10% penalty for withdrawing the money in addition to your regular income taxes. To make matters worse, if you withdraw a large portion of money from an IRA, it may actually push you into the next tax bracket. Assuming a 30% tax bracket, if you pull out $10,000, you will pay $1,000 in penalties and $3,000 in taxes. Thus, you are losing $10,000 in your retirement portfolio, and you only get $6,000 of it. Not a very good deal. If you pulled out enough to knock you into the next tax bracket, you would end up paying even more because a portion of that $10,000 may be taxed at 35%. As you can see, it pays to keep your money in your retirement plan.
Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.