The 20 somethings Financial Need-to-knows

Bill DAlessandro is an entrepreneur and former investment banker living in Denver, Colorado. He also writes “Ready, Fire, Aim” a blog about entrepreneurship, finance and lifestyle design. Bill has been managing his own finances since high school and has made a ton of mistakes, so pay attention, he kind of knows what he’s talking about.

My younger brother just graduated from college this year and is getting settled into a new job, life on his own, and financial independence. Along with his first paycheck, he’s also been bombarded with a lot of new financial choices and a lot of acronyms (IRA, 401k, APR, etc). Everyone knows they should be saving money, but the reality is that nobody ever tells you exactly how to go about it short of stuffing cash under your mattress. This post isn’t going to be an in depth discussion of what stocks to buy or how much of your net worth to put in bonds – rather, I want to focus on the mechanics of how to organize your finances as a single, newly independent young adult in order to set yourself up for prosperity and success.

The 401k

Ah, the first decision you’re going to have to make – how much of your paycheck do you want to allocate into your 401k? The most important thing to know about a 401k is that any money you contribute is “pre-tax”, meaning that it is taken out of your paycheck before taxes are calculated. This is the first way a 401k gives you “free” money – you’re able to sock it away before the government takes a cut. The second way a 401k gives you free money is an employer match. Policies vary among companies, but most offer a match of some kind, up to a certain percentage of your salary. Always, always contribute enough to your 401k to receive the full matching amount that your employer offers – this is literally money in your pocket as an incentive to save. After you’ve received the full employer match, it’s my advice that you don’t contribute anything further to your 401k right now. I’ll explain why in a minute.

Once you’ve got some money in your 401k, you’ll be asked what type of fund you wish to invest it in. You’ll have a lot of options, but your best bet is to select a “target retirement fund”. Add 40 years to the current date, and that’s roughly the year you should hope to retire. These target retirement funds will automatically keep you in equities while you’re young for maximum return, while gradually shifting to bonds for income and protection as you age. Set it and forget it. One thing to be sure of: make sure your 401k is invested in a broad-based fund, not exclusively in the stock of your employer. That’s a lot of eggs in one basket – just ask anyone that spent their career at Wachovia or Bear Stearns.

The Roth IRA

So now you’ve saved a few percent of your paycheck in your 401k (just enough to receive your employer match), but you still have some extra cash remaining that you can afford to lock away for retirement. Your next option is an account called a Roth IRA. Contributions to a Roth IRA are “post-tax”, meaning they come out of your wallet after you’ve already paid income taxes to the government. However, the big benefit to a Roth IRA is that once you’ve contributed, your money grows tax free, forever. That means when you retire, you can withdraw the full amount without paying a dime of taxes on the money you contributed OR on your capital gains. That means you never pay any taxes on all the compounded interest your money made you over the years. And after 40 years of compunding, that’s significant.

You can open a Roth IRA with nearly any investment company (Fidelity, Charles Schwab, TradeKing, and many more), though it may be easiest to use whichever company your employer uses to administer your 401k. There are two major rules regarding Roth IRAs – 1.) You may contribute a maximum of $5,000 each year. You can do this all at once or over the course of the year, but your total contributions may not exceed $5,000. And 2.) You may only contribute to a Roth IRA if you make less than $105,000/year. While this may not be an issue for you now, it hopefully will be in the future, so get those contributions in while you can so they can grow tax-free over the course of your career.

In order to contribute to your Roth IRA, write yourself a check and mail it to your investment company; they will deposit it in an account in your name. The best way to do this is to mail in a check for $416.66 each month ($5,000/12). This will help you in your budgeting, and also keep you disciplined.

Your Checking Account

Speaking of writing checks, now that you’ve contributed to your 401k and Roth IRA, it’s time to make sure you have some “walking around money”. For that, you’ll need a checking account. A checking account provides you with quick, easy access to your money through ATMs, checks, and a debit card. This is the money you’ll use to pay your rent, cover your tab at happy hour, and buy that electric guitar you’ve always wanted.

You can get a checking account from any bank in the country, but far and away the best choice is Charles Schwab Investor Checking. Their two most attractive account features are 0.5% interest (compared with 0% at most banks) and unlimited, free use of any ATM in the world. I can’t stress this second point enough – no more wandering around town to find a specific bank’s ATM, no more paying a $3 “convenience fee” at the gas station. It’s all free, anywhere, all the time. I want mention that I’m not paid by Schwab and that’s not a referral link. I just think they’re awesome (and have been a customer for 4 years myself).

Once you’ve got your checking account open, set up direct deposit with your employer. They’ll drop your paychecks directly into your checking account, and you won’t need to worry about cashing checks every 2 weeks.

So now that the money is streaming in, should you just let it pile up in your checking account? My advice is to keep about $5,000 in your checking account for day-to-day use and personal spending, and get the rest out of there so it’s mentally earmarked for saving or a rainy day. So where should you put any left over money after your 401k and Roth IRA are maxed out, and you have $5,000 in your checking account?

Investing in Mutual Funds and Stocks

If you still have money left over, it’s time to think about investing in individual stocks or mutual funds. Lots of people that are smarter than me (and many who are not) have written miles of text on which stocks and funds you should and shouldn’t buy (caveat investor), so I’ll avoid telling you what to buy and focus on how you buy it.

You’ll need a brokerage account. As with your checking account, there are countless firms that can give you what you need here, but be aware of fees. If you’re only investing a few thousand dollars, commissions can significantly eat into your profits. That’s why I want to make another recommendation – use TradeKing as your broker. Commissions are only $4.95 per trade (the lowest I’ve found anywhere), and they’ll let you trade stocks, options, and mutual funds. Again, they’re not paying me a dime – I just genuinely think they’re the best option.

Once you transfer some money into your brokerage account, it’s time to buy some stocks. Pick up the Wall Street Journal, read the news, and educate yourself – this is a good chance for you to start to learn about investing while the stakes are relatively low. Think long term – remember, you’re investing not trading. Be aware of capital gains tax laws – any profits from a position you hold for under 1 year are taxed as normal income at your normal tax rate (which could be as high as 30%). But if you hold a position for longer than a year, you pay only the long term capital gains rate of between 0% and 15% (depending on your tax bracket). So keep that in mind when you’re tempted to trade quickly in and out of stocks.

If you don’t have the time, knowledge, or inclination to pick individual stocks, you can use your TradeKing account to purchase nearly any of Vanguard’s 100+ index funds – all you need are their tickers, which you can find and research on Vanguard’s site here. While everyone’s investment objectives are different, if you want a set it and forget it index fund.

In Summary

So there you have it – a complete blueprint to getting organized financially in the real world. Let’s sum up the structure we’ve set up for you:

• 401k Contribution — Enough to receive your full employer match, no more (every paycheck)
• Roth IRA — $5,000 per year (one $416.66 contribution each month)
• Checking Account — Consistent $5,000 balance for every day expenses, direct deposit, free ATM use
• Brokerage Account — Any additional savings are invested in stocks or mutual funds for the long term

If you’re able to follow the blueprint I’ve laid out above, you will not only be able to sleep well at night knowing you’re doing the right things with your money, but also will have set yourself up with a framework to save responsibly over time and build wealth in the long term.