What Every Millennial Needs To Know About Saving And Finance

401(k), IRA, retirement, oh my! posted on

What is the difference between a 401(k) and an IRA? Is one better than the other?

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The main difference between a 401(k) and an IRA is who administers it. Your employer can run a 401(k) plan that you choose to sign up for, while an IRA is managed individually.

With 401(k) plans, you can contribute up to $17,500 in pre-tax income to your 401(k) and your employer can match your contributions. This is as close to free money as you can get and is by far the best deal in personal finance. Income on a 401(k) is pre-tax, meaning that for what you contribute up to the limit, your income for tax purposes goes down.

IRAs, on the other hand, have nothing to do with your employer. You have to sign up for one yourself through a bank or brokerage. Traditional IRAs have a similar tax advantage to 401(k) plans, but a lower contribution limit ($5,500).

2. How much should I put into my 401(k) each paycheck? How do I decide where to invest it?

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The most important guideline for investing in a 401(k) is to contribute up to the level that your employer matches. As previously mentioned, this is the best deal in personal finance since it’s as close to free money as exists anywhere. After that, it really depends on how much you have in other forms of saving and what goals you have (see the next question).

As for where to invest it, it really depends on what your employer offers. Your employer will offer you a range of plans that should differ in risk and expense. A good rule of thumb is that when you’re younger, your investments should be weighted toward stocks, which grow quicker, and should gradually shift to bonds, which are safer, when you get closer to retirement.

Target-date funds help achieve this transition for you. They’re a type of fund that adjusts the mix of stock and bonds over time to get close to the optimal mix.

But if you’re picking funds yourself, it is very, very difficult to know which ones will perform well decades into the future. What’s not difficult is to see which ones are the cheapest right now. Mutual funds that you pick through your 401(k) have disclosure requirements for how much the fund spends every year in expenses. When you can’t really tell the difference between two reasonable options, picking the cheaper one is a pretty good rule of thumb.

John Bogle, the founder of the mutual fund company Vanguard that pioneered low-cost mutual fund investing, puts it simply: “Fund investors are confident that they can easily select superior fund managers. They are wrong.”

4. If I’m 25 now, how much do I need to save to be able to retire at 67?

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Fidelity, the massive investing company that handles the retirement savings of millions, has a rule of thumb that’s not the only way to save, but a way. Its basic guideline is to, by the time you retire at 67, have eight times your last year’s salary saved for retirement.

Impossible, right?

No.

Here’s the trick, as you grow older, your savings accumulate much faster because of the magic of compounding. A 5.5% gain on $200,000 worth of investments is much larger than 5.5% gain on $10,000.

So, at 25, you’re expected to have essentially zero savings and you’re only expected to get to saving your annual salary by the time you’re 35. The guideline for getting there assumes that your investment portfolio grows at a certain rate and that you gradually up your savings from 6% of your salary up to 12% in 1% increments each year.

6. How the hell does my credit score work?

There are five main factors to your credit score.

The first is payment history, which is a record of whether or not you’re paying your debts on time.

The second largest component is how much you owe, or “credit utilization.” Large balances, at or near your credit limit, hurt your credit score. The third is how long you’ve had credit. This leads to the slightly weird situation in which you might have to take on more credit for a longer period of time to get the highest credit score. As you build a longer credit history, providing you’re not maxing out or missing payments, your score will go up.

There’s also what’s known as the credit mix, which accounts for only 10% of the score. This is a measure of the different types of credit you have, whether it’s revolving credit, like credit cards, or installment credit, which has a fixed repayment schedule. And finally there’s “new credit,” which is a little more vague, but it’s basically bad to open a bunch of different lines of credit in a short time period.

The rules of good credit are rather straightforward. Have some credit history, don’t try to borrow as much as possible, and make your payments on time.

8. How can I use my credit card responsibly?

The basics for responsible credit card use are pretty…basic. Avoid only making the minimum payment more than is strictly necessary: Repeated minimum payments is a recipe for paying much, much more in interest down the line. And no matter what, pay on time: Credit card companies feast on fees from their customers.

While credit cards offer convenience, rewards, and the ability to buy stuff using your future income, getting in credit card hell is much worse than the benefits of responsible use. If you can’t handle a credit card, don’t get one.

But if you are using a credit card frequently, make sure you maximize your rewards. Although various reward programs may seem indistinguishable or useless (when am I going to use those restaurant reservations? Knicks tickets? Really?), there are real differences between them and picking a subpar one is just leaving money on the table.

10. Is it true you should have six months salary saved for emergencies?

Well, yes. But just because that goal seems unattainable doesn’t mean you shouldn’t start.

Since your take-home pay should already be heavily devoted to saving, saving for an additional emergency fund can seem like a tough haul.

But that doesn’t mean you shouldn’t have a large amount of money that’s immediately accessible for true financial emergencies. Also, when you do have this amount saved, you can basically stop.

And here’s why you should: The average unemployment spell is over eight months and the median is four months. A period of unemployment is one of those things, like a huge medical expense, that can lead you into true financial ruin, not just discomfort. And so it’s one of those things you should insure yourself against by paying now to protect yourself later.

12. How much should you put down if you are buying a house? What is a good mortgage interest rate?

There’s no one answer to this. Whether or not you should buy a home depends a lot on your income, your prospects for future income, the price of housing in the area you’re living in, and prevailing mortgage rates. And since a house is such a large expense, if you can only buy if you can get the lowest possible mortgage rate, you probably shouldn’t be buying in the first place.

But there is a clear connection in the research between high down payments and lower chances of default in the future. Somewhere between 10 and 20% down is widely thought to be the sweet spot for drastically reducing your risk of default and then foreclosure.

Without much money down — what’s known as equity — you don’t really “own” your home and any major change to your financial situation risks you losing it entirely. But when you do have significant equity in your home, you can withstand large swings in your home’s value and even some financial shocks without worrying about losing it to the bank.

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