Publish date:

A Beginner's Guide to Making Smart Financial Decisions

Behold, the definitive step-by-step guide to financial literacy (and freedom) you've been searching for.

I’ll start with a full disclosure­­—I’m new to the world of financial writing. I didn’t even know exactly what a 401(k) was, never mind the difference between a Roth and a traditional IRA. No, I didn’t lie on my resume, just a bit of background is needed here: I’m an intern (co-op technically) completing my journalism degree at Northeastern University. I’m a third-year student, who prior to this position at Retirement Daily, was covering local Boston news and art gallery openings.

I’ll admit there’s an upper hand to being green to the retirement industry. I can write explainers on policies without adding confusing lay terms that one more well-versed in the topic may include. But while I write articles on IPOs, Medicare penalties, and 401(k) legislation, I’ve come to notice a sense of confusion on how to become more financially literate. As myself and my twenty-something year-old peers begin to start our professional careers and are making larger sums of money, I've kept asking myself the same question when it comes to personal finance (feel free to add an expletive of your choice):

Where the **** do I start?”

Behold, a step-by-step guide to financial literacy (and freedom!), organized and researched by yours truly so you don’t have to.

The Basics

The first thing that I’ve consistently heard from financial advisers is the importance of budgeting. This can be as simple as creating a spreadsheet or using a mobile app, such as Mint or PocketGuard. It’s important to keep track of not only the money that you’re bringing in, but the money that’s spent. List the essentials—whether it be rent, utilities, bills, car payments, etcetera.

Next, add in the more flexible (or in the jargon of financial advisers, discretionary) aspects of your budget, such as food, clothing, and eating out. You may realize that while you enjoy “the vibe” of that Certified Humane Organic Local Artisanal coffee shop, spending $5 dollars for a cold brew adds up. What can you adjust? If you can’t go without the cold brew, maybe that means taking the bus instead of an Uber. I’ve recently had a wake-up call with my Uber bill and have now recognized “no sober Ubers” as my personal mantra.

Future Spending

Now that you’ve taken a look at your current income and expenses, it’s time to broaden your horizons a bit. What are your financial goals? Split them into a few groups: short-term, intermediate-term, and long-term.

Before you start saving for these goals, however, it’s important that you have an emergency fund with at least three to six months of living expenses in a high-yield savings account. You can find these types of accounts at websites such as Bankrate.com.

For the short-term, maybe you’d like to save up for a spring break trip or new furniture. Intermediate-term goals are ones that in three to five years you’d like to achieve. Maybe that’s a down payment on a house, going to grad school, or buying a new car. Be sure that any outstanding debts such as credit card debt are paid before saving for long-term.

While there’s a difference of opinion among financial advisers, I’ve found that it’s best to pay down credit card and other short-term debt before saving for long-term goals.

For goals that will take a few years to achieve, it might make sense to create separate accounts to make sure that money isn’t being touched. The key here is to keep these savings in a “high yield” account, meaning that you’ll be earning a larger amount of interest than a typical savings account.

Now for our long-term goal: retirement. I know it seems like light-years away, but I like to take a look at compound interest when I feel that it’s too early to start saving. Here are some numbers that I got from this interest calculator.

If I start with $300 dollars, and contribute only $100 every month for the next 35 years with an 8% interest rate (rates are typically between 7 and 10 percent) that’s compounded annually, I’ll have around $211,000. As you progress throughout your career, your monthly contributions will also most likely change, generating even more money.

However, let’s say I started saving in five years. With the same contribution amounts, I would only end up with about $139,000.

If you start with $100 and contribute $465 every month for 40 years at an 8% rate, you’ll have $1.4 million in retirement savings.

FOMO is also a real thing here. A Pew Research study found that about three-in-10 U.S. adults say they worry every day or almost every day about the amount of debt they have and their ability to save for retirement. In a survey by TD Ameritrade, 68% of adults said that they would tell their younger selves to start saving earlier.

Take Advantage of Free Money

Check with your company to see if a 401(k) matching plan is available. This means that for every dollar that you contribute (up to a certain amount), your employer will “match” a percent of what you put into your plan. Many overlook this easy way to start saving, and go straight to saving outside their 401(k). What they’re neglecting to notice is that they’re missing out on the opportunity to get extra cash – free money – from their employers.

You might have the option of saving either in a traditional 401(k) or a Roth 401(k). If you do have such an option, consider saving in your Roth 401(k). You’ll contribute after-tax dollars to that account and your company will contribute its match to your traditional 401(k) with pre-tax dollars. I know it sounds complicated, but stick with me here; the reason why you might want to do this has to do with taxes. Roth accounts, which are funded with after-tax dollars, grow tax-free and distributions are tax-free as well.

 These accounts work well for someone who might be in a lower tax bracket now but a higher tax bracket during retirement. If, however, you’re in a high tax bracket now and expect to be in a lower tax bracket in retirement, you might consider contributing to the traditional 401(k) instead of the Roth 401(k).

Once you’ve maxed out any matching contributions, and assuming you have additional money to save, you have a few options: You could contribute even more to your 401(k), or you could contribute either to a traditional individual retirement account (IRA) or a Roth IRA, or even a taxable account.

You already have a handle on the 401(k) option, but if your company doesn’t offer a 401(k) plan (or you’ve maxed out your contribution), you should also consider an IRA. IRA accounts, as the name suggests, are for retirement. The rules for taking money out of either a traditional IRA or Roth IRA are different. 

Generally, according to the IRS, early withdrawal from a traditional IRA prior to age 59½ is subject to being included in gross income plus a 10 percent additional tax penalty. There are exceptions to the 10 percent penalty, such as using IRA funds to pay your medical insurance premium after a job loss. Read the IRS’s Hardships, Early Withdrawals and Loans for more information. The rules for taking distributions and withdrawals from a Roth IRA can be found at the IRS's Publication 590-B.

Contributions to a traditional IRA are tax-deductible but you must then pay tax at ordinary income rates when you withdraw the money after age 59 ½. It’s savvy to use these accounts if you want to lower your taxable income. The benefits of doing so allow you to qualify for other perks, such as tax credits if you have children or are paying off loans.

Again, if you’re in a low tax-bracket, a Roth may make more sense. Like a Roth 401(k), you would contribute after-tax dollars and your money would grow tax free and, if you satisfy the requirements, qualified distributions are tax-free, according to the IRS. One other advantage of a Roth IRA versus a traditional IRA is this: traditional IRAs have required minimum distributions or RMDS starting at age 72 but Roth IRAs don’t have RMDs.

A thing to note about IRAs—there are rules regarding how much and whether you can contribute. Check out the IRS’s website for more info. 

Investing

Now for the fun stuff, it’s time to invest your money. You can invest in many ways, but for these purposes, I’ll first talk about the difference between investing using a taxable brokerage account versus an IRA or your 401(k).

In general, it’s a good idea to consider account location and tax efficiency when deciding how to invest the money in each of your accounts: traditional IRA or Roth IRA; traditional; 401(k) or Roth 401(k); and taxable accounts. There are several resources to help you learn which investments, based on how they are taxed, are best suited for which types of accounts. This article goes more in-depth about different tax rules regarding investments.

Despite how complicated all this might seem, there’s one bit of good news.

The days of needing a significant amount of money to start investing are over. Instead of buying stocks at full price, many brokers offer the ability to buy fractional shares of your favorite stocks. Let’s say you’re a devoted fan of Apple but can’t chalk up over $145 dollars for a share, or you’d rather diversify with the limited money that you have. You can now buy smaller shares of these companies and still make money along the way.

Where exactly to place your funds? That’s the million-dollar question. Again, there are so many options. Experts suggest that if you’re just starting off, a passive investing route may be the way to go. Compared to active investing, in which someone (or yourself) manages your funds and tries to “beat the market,” passive investing involves placing your money in a few funds, say an ETF that tracks the Standard & Poor’s 500 stock index or the Nasdaq 100, and watching it grow periodically on the sidelines.

Especially when you haven’t acquired a lot of wealth, “beating the market” is difficult and sometimes won’t even benefit you in the long run. Portfolio managers also charge fees for managing your funds, so you may end up spending more than you’re earning. Vanguard Investments, for all those new to investing, is viewed as the firm that first promoted the notion of low-cost investing for the average retail investor (the term used for non-professional, individual investors). Their site features a good deal of educational material for those new to investing.

Buying passive index funds also helps you diversify your portfolio and manage risk in ways that you can’t necessarily do when buying individual stocks and bonds.

If you invest in an S&P 500 ETF and one of the 500 companies’ prices go down, your money won’t feel the effect so drastically, as you have other holdings to even the blow.

Again, there are so many sectors to invest in, whether it be the S&P 500, total market index funds, international index funds, and emerging markets. A personal favorite that I’ve been watching are ESG (environmental, social, and governance) index funds, which are companies that may focus on sustainable practices or feature inclusive leadership within the corporation, amongst many other criteria.

When investing, either in active or passive funds, be mindful of fees. Passively managed funds can have expense ratios that are under 0.2% while actively managed funds tend to range between 0.5 to 1.5%. While they may seem like nominal decimal values, these fees add up with larger sums of money.

Many mutual funds do require a specific minimum to start investing, however, there are also options for ones that don’t require a minimum as well.

If you buy a share of a company, whether it be through mutual funds or individual stocks, you are a partial owner of that company. With that in mind, make sure that the companies in which you invest are ones that you care about and believe in their mission. After all, you’re funding their progress!

What’s Next?

The main takeaway from my research journey has been that starting is the hardest yet most important part. Don’t worry about whether or not you’re making the “right choice” when it comes to investments. Having a less-savvy plan is more important than not having a plan at all. Don’t drive yourself crazy with numbers, market watching, and obsessively checking your funds. It’s a good idea to check your balances periodically, say once a quarter. It’s also vital that you consider these investments not as a way to get rich quick, but rather a way to earn slowly, thanks to power of compounding interest.

Who knows? If you start making more financially sound decisions right now, you may see that some of your goals aren’t really that far away. Again, the time to start saving is now. What are you waiting for?