The 2 Most Important Financial Steps to Take in Your 20s
Most Americans don’t learn how to manage their finances in high school or college. As a result, it can be overwhelming to start your life as a young professional and navigate conflicting advice about “smart” financial decisions. Over the last ten years, financial literacy for 18-34-year-olds has almost been cut in half, according to a 2018 study.
When you get that first job offer (especially after years in college with close to zero income), even an entry-level salary can feel like you’ve won the lottery. Grab the new iPhone! How about a bigger TV? Why deal with roommates when you can live alone? Why think about saving for retirement? That’s decades away!
But as the first credit card statements come in, you realize quickly that the world is more expensive than you thought (especially in big cities where the annual cost of living for a single young professional can be $30-40k / year.) What if a pandemic hits and you lose your job? Unfortunately, we know both of these scenarios are all too real. It takes discipline to set a clear financial direction for your life and ensure you’re prioritizing your long-term financial freedom. Sen. Ben Sasse (R-Neb) puts it well in a 2017 Wall Street Journal essay: “Part of learning to be an adult is figuring out that our real needs can be separated from the insistent call of our wants.”
Build Your Emergency Fund
One of the first things you should focus on as a young professional is building a stable emergency fund of 3-6 months expenses (including rent, food, utilities, and other essentials). If you lose your job, you want to have this “buffer zone” to minimize financial stress while you search for a new job. According to the same study above, 60% of 18-34-year-olds don’t have three months of expenses saved up, which is a big risk in a world of uncertainty.
No one likes budgeting, so I find it’s easiest for many people to “pay yourself first” – set aside a set percentage (e.g., 20% or more if you can) immediately from each paycheck. Once you’ve hit that savings target each month, you don’t have to stress as much about restricting your other expenses from what’s left, though tools like Mint, Personal Capital, and You Need a Budget (YNAB) can help you find other saving opportunities. If you have student debt from college, still try to save at least 3 months of living expenses first. Once you have that safety net, you can focus your savings from each paycheck on knocking out the debt as quickly as possible.
People often ask me if they should invest their emergency fund. Generally, no – the purpose of the emergency fund is to be “liquid” – available to withdraw as soon as you need it most (rather than investments that could drop in value right when you need the cash!) But you should still think strategically about where to actually store your emergency fund. High-yield savings accounts or money-market funds can give you a little bit of a return (better than big-bank savings accounts with essentially zero interest) without the volatility/risk of other investments. They’re running at about 0.5% per year right now, though pre-COVID they were around ~2% per year in interest.
Start Saving for Retirement
Once you have that emergency fund built up, it’s time to think strategically about retirement. Yes, it may be 30 or 40 years away, but that’s actually one of your biggest advantages. Let’s say you start at 24 (after building up that emergency fund first!) If you contribute just $3,000 per year (10% of an entry-level salary on the Hill) to a retirement account for only 10 years and then never contribute again, you’d have more than $500k saved up by age 65 from your total contributions of only $30k! (Assumes for simplicity an 8% average annual return with minimal fees, as if you contributed to a broadly-diversified stock market fund or a target-date fund, which are often the default in many employer-sponsored retirement accounts.)
Let’s say you wait ten years to “enjoy your 20s” and make those $3,000/year retirement contributions from age 34 until age 44. Though you contributed the same amount ($30k), waiting ten years means that you only have around $230k saved up at age 65 – less than half of the amount from starting in your 20s!
The bottom line? Starting early will really pay off. You can start saving for retirement today through an employer-sponsored plan (e.g., 401(k) for private employers, 403(b) for many non-profits, or Thrift Savings Plan for federal employees) or by opening your own IRA (individual retirement account). If you keep consistent and don’t stop (e.g., contribute $3,000 to retirement from age 24 to 65), you’ll be close to a millionaire by the time you’re ready to retire.
Around this time, you’ll also start getting emails and LinkedIn messages from old acquaintances offering to be your “financial advisor” so they can “help you secure your financial future” (which usually means sell you insurance). Use extreme caution in these conversations and always talk to another expert (preferably someone you don’t have a personal relationship with) before signing up for anything. “Friends don’t let friends sell them life insurance,” says Matt Becker, a Certified Financial Planner® on his popular blog Mom & Dad Money. Focus on getting your savings and retirement investing strategy down first, then you can focus on setting up term life insurance once you have a family.
Finally, don’t be afraid to talk about your finances with trusted friends and family. Being open and honest about your finances will help you be confident that you’re on the right path.