Congratulations to the class of 2017!
This week's episode of Industry Focus: Financials is for all the new graduates out there who are either going into the working world or heading to college. Motley Fool finance experts Gaby Lapera and Dan Caplinger explain how student loan debt works, how it's different from other types of debt, and how to make sure you stay on top of your payments. The duo also discuss what you need to know about W-2 forms, tax withholdings, 401(k)s, and IRA. Finally, they explain the difference between a Roth and a traditional IRA/401(k), as well as what to look for when selecting a fund for your retirement savings.
A full transcript follows the video.
This video was recorded on June 19, 2017.
Gaby Lapera: Hello everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped on Monday, June 19, 2017. My name is Gaby Lapera and joining me on Skype is Dan Caplinger, Motley Fool personal finance expert and stock expert, and plane-flying expert, just a super expert kind of guy. [laughs] Hey, Dan!
Dan Caplinger: How are you doing, Gaby?
Lapera: Pretty good, feeling kind of sassy, don't know if you can tell.
Caplinger: All good with me.
Lapera: As usual, since we have Dan on the show, we're going to do a more personal finance take on financials, because financials can be banks, but it can also be your money in the bank. We're going to hit two topics today, because today's episode is dedicated to the class of 2017, who graduated recently. Congratulations! I'm sure that that first cold shower of life outside of school has already hit you, and we want to help. Let's talk a little bit about your student loans, and then let's talk about your first job. Dan, student loans, something that you have to look forward to with your children, probably.
Caplinger: Yeah, probably. I have a few years left on that one. My daughter is graduating from elementary school this year -- a momentous occasion, but we still have some time to save up on those college funds. But, congratulations to those of you who have finished up with college, but unfortunately, it's time to pay the piper, because often, what happens with student loans is, many will give you a deferment while you're still in school where you don't have to make payments back. But then, pretty soon after you graduate, they're coming out with hand out waiting for you to start making your first monthly payments. So, it's something you really need to keep track of and understand what your obligations are going to be going forward.
Lapera: Definitely. I think one of the most important things to note is that you absolutely need to pay these loans. Sometimes people get really overwhelmed by them, and they're like, "I'm not going to think about it, I'm not going to pay it," but this is a really bad idea with these loans because the interest just keeps accruing, and unlike other types of debt, these cannot be discharged in bankruptcy. So even if you declare bankruptcy, these loans are still there to haunt you.
Caplinger: That's right. Also, on that same note, if you try to just ignore things, you can expect things like late payment fees, failure to pay fees, to add up, because the financial institutions that make these loans usually have those provisions in the fine print. So, the best thing to do if you find yourself in a jam is be upfront about it. Talk to the people who are servicing your loans. You are not alone, you are not the only person who's having trouble, and there's actually some pretty helpful things that lenders can do to try to help and make it easier for you to be current, to meet your obligations, to pay things off, but not get yourself in trouble.
Lapera: Yeah. As Dan said, the most important thing is to call your lenders and try to figure something out. I know it might seem like they're monsters, but there are people on the other side of the phone, and it's in their best interest that you be able to pay these loans, as opposed to just completely default on them. So, they will try and help you. Dan, do you want to go over a couple of the things that they might be able to do for you?
Caplinger: A couple of things that they can do are, in some cases, they can arrange for and additional emergency deferment, where interest will continue to accrue, but you may get a few months off where you don't have to make payments, might not have to make full payments, they might give you a discount or something like that. The other thing that folks can do is try to work with you on what's called a consolidation loan, and that basically takes all of your student loans, combines them into one package, so you have one payment to make. Then, it can sometimes change the repayment terms, extending the life of the loan for a longer period of time. That obviously means you're going to pay more in interest charges over the lifetime of the loan, but what it does is reduce the monthly payment. And sometimes, that's the most important thing, especially for folks just coming out of school, who might not have a job or have the job that you eventually want. It's a good stopgap in order to keep you moving forward and not get in trouble.
Lapera: Yeah. And with the consolidation, something you can look for is, sometimes the rates on student loans are kind of high. Sometimes, with consolidation, you can get the interest rates lower, and that will obviously help also lower your monthly payment, and your payments over time.
Caplinger: That's right. The other thing that you should look into is, there are loan forgiveness programs for certain types of loans. Those are the sort of things, you may have heard about them doing certain types of public service, if you do it for a long enough period of time after you graduate, then you can get a portion -- or even some of the provisions forgive all of your loan indebtedness -- after you work for a certain number of years. So, take a look at that and see if it applies to your chosen profession, and the kind of job you might be interested in doing.
Lapera: Generally, the jobs that are included in there are government work, there's teacher loan forgiveness, doctor loan forgiveness in certain states, and nurses' loan forgiveness in almost every state and federally as well. There's also some income-based repayment plans. That's if your total student loan debt creates such a financial hardship that it's going to be basically impossible for you to pay, so they lower the amount of payments that you have to make, it's capped at a certain percentage of your income, and after paying off those loans for 20-25 years -- so, this isn't exactly a great deal -- sometimes they will forgive the entirety of your debt. So, that's also something to look into. I hope you're not in that position.
Caplinger: This space is evolving quickly that those sorts of solutions make people start looking into ways to make things work on a long-term basis, and stuff like that income-based repayment is relatively new, but it's something that people are really taking into account, the fact that student loan debt is a big problem going forward, and we need to do something to make it more manageable.
Lapera: Definitely. Just a reminder that sometimes when you have student loan forgiveness, when those loans are forgiven, they are counted as income for your taxes that year, so you might be hit with a big tax bill, so definitely look into that before you get all of your loan forgiven all at once, and suddenly it looks like you made $100,000 that year. And, before I forget, there's one other thing. You can get your loans deferred if you talk to your lenders, for a couple months. The other way to get loan deferments is if you go on to grad school, if you're in the Peace Corps, if you're active military, or if you're in a rehab facility of some kind -- it wasn't exactly 100% clear to me what kind of rehab facility, but it looks like they give you a deferment for the time that you are an inpatient in that type of facility. So, something to keep in mind, if you're not working or if you're in any of those other fields.
Caplinger: Again, check with your lender if you're uncertain about a situation that you're in. They'll be surprisingly helpful in working with you, in most cases.
Lapera: Yeah. So, after talking about your student loans and some tax considerations, we should probably talk about what to do with your brand-new shiny job. Let's talk a little bit about some stuff you need to know about working. Let's start with tax withholding. This is one of the first things you are going to do when you get a job, someone is going to hand you a W-4. Dan, will you tell us what a W-4 is?
Caplinger: That's right. The first day of any new job is incredibly stressful, because there's so many people talking to you, trying to teach you what you need to know for the beginning of your career, handing you all kinds of paperwork. One of the first things you are going to get from the humans resources people at your company is this form, W-4. Basically, what it does is set the foundation for how much, in taxes, you're going to have withheld from each year's paychecks. The reason that's important is, if you don't have enough money withheld from your paycheck, you're going to end up owing taxes at the end of the year, and you can even owe penalties. On the other hand, if you have too much money withheld, your paychecks will be unnecessarily small, and even though you'll get it all back in the form of a really big refund when you file your taxes, you will have essentially given the IRS a free interest-free loan for the whole year. And for someone who's just starting out and needs those paychecks to be as big as possible, that's really not what you want to happen. So, the W-4, there are instructions that will walk you through how you need to fill that out. But basically, what it does is tells your employer how to calculate how much money to have withheld from your paycheck, so that your tax situation works out the way you want it to.
Lapera: Yeah. The place that that money is going, if you're curious, is the federal government, and it's to pay for stuff like Social Security or Medicare. You can actually see it broken out on your paycheck -- or, you should be able to. If you can't, then your HR department is doing something terribly wrong, and maybe you should find another job. Something also to keep in mind is that if you're self-employed these might not 100% apply to you, you're going to have different tax things apply to you. This is something for people who have a job at a company that's going to pay for half of these taxes.
Caplinger: That's a good point, Gaby. If you're self-employed -- that means if you're working not as an employee but as an independent contractor, even if you're doing most of your work for one company -- if you're treated as an independent contractor, they're not going to withhold any taxes whatsoever from your paycheck. It's going to be all up to you to make sure that you pay attention to how much in tax you're going to owe, and then send that to the IRS in the form of quarterly estimated payments. It's only if you are an employee that your employer does this for you automatically with the W-4.
Lapera: Yeah, so definitely keep that in mind. The other thing I wanted to mention is, I actually didn't know this until we went to tape the show -- you cannot claim the same withholding allowances with two employers at the same time. Did you know that, Dan?
Caplinger: Huh, I did not know that.
Lapera: Yeah, according to the IRS website. So, definitely keep that in mind. Also, the other thing to keep in mind is, don't forget to update your W-4 if you've had some sort of life event that would necessitate you to update it. For example, if you got a divorce, you're awfully young, but you're just moving through life a little bit faster than others, I guess, or if you have a child, that's another reason why you might need to update your W-4. Can you think of any other scenarios, Dan?
Caplinger: Keep in mind, this is the sort of thing, if you work for the same company for a long time, you might go years and never see this form again. So, even if you're not thinking about getting married or having a family now, just bury it in the back of your mind that, when that time comes, it's time to take a look at this W-4 again. And you will notice that when you follow the instructions, it will have different ways to fill out the form depending on whether you're married or single, whether you have kids or not. It's designed to be as easy as possible so you don't have to do the math. It leaves it up to your employer to do the math. And when they do, it will adjust to account for your different tax situation as you go through those life events.
Lapera: And the reason you should care about this is, if you do get married or have a kid, there's a lower withholding rate, so you'll get to keep more of your paycheck. OK, that mostly takes care of taxes. Obviously, talk to a tax professional or your HR person to get some extra help if you need it. Let's talk about the other really important thing when you first start working. Hopefully you're working at a company that offers this. You start work, you're handed all this paperwork, and among that paperwork is 401(k) paperwork. Dan, tell us about 401(k)s.
Caplinger: Basically, the 401(k) is a way for you to get a jump start on saving for retirement. That might be the thing that you think is the furthest from your mind, but there are some really good reasons why you ought to think about putting at least a small amount of money toward your retirement. The first and most important is that most employers are going to make it worth your while to put a small percentage of your salary in your 401(k). The way that they do that is by matching your contribution. For instance, a lot of companies, if you save up just 3%, $0.03 out of every dollar that you make, they will match that with an equal amount from their own pocket. Basically, if you're making $200 out of every paycheck, 3% of that is $6, so your $6 will go into the 401(k), and then your employer will add an additional $6 in there. Now, that doesn't sound like much, and it's not, when you first start out. But over time, it builds up. And over time, as your salary goes up, those percentages automatically adjust as well. So, the combination of those two things, along with the investment growth that you get along the way, can really help you turn what seems like small amounts of money into enough to help give you the retirement security that you need after the end of your career.
Lapera: Yeah. And just to be clear, guys: This is free money. You don't have to do anything extra to get it, you just have to make sure that you put money into your 401(k). The other thing you want to do is make sure you max out your match. If your employer offers up to 9% matching, put 9% of your paycheck into the 401(k). And if you do it as soon as you start working -- because you can elect how much goes into your 401(k) with all of that initial documentation -- you won't even miss the money, because you won't be used to seeing it in your bank account. So, once you have your 401(k) open, depending on your employer, you will be able to go in and pick what funds you put your money into. The funds are generally index funds, mutual funds, ETFs. They have a variety of different characteristics, and we're going to give you a little bit of advice on how to pick on that best suits you. For me, the most important thing is fees.
Caplinger: I agree with that 100%. Fees are something that, basically every dollar that goes to the company that manages your 401(k) is a dollar that is taken away from you. So, picking funds like index funds that have low expenses are really usually the best way to go, especially for someone who's just starting out.
Lapera: Definitely. Generally, if you see a fee that is 1% or more, that is way too high. Honestly, anything above 0.7% or 0.5% is way too high for me. You can get funds with extremely low fees. The Vanguard S&P 500, one that I have, is 0.05%. Those are the ones you want to be looking for. And you might not think it adds up over time, but if you want, I will send you an article that explains how those fees cut into your returns over time.
Caplinger: Yeah, it's extraordinarily surprising to find out. And again, it's because these dollar amounts grow over time. If you're only making a $6 contribution, it doesn't make that much of a difference. 1% of $0.06, 0.5% is $0.03, it's not a big deal. But, as these monies grow and accumulate, then suddenly you're starting to talk about real money, and even these small percentages really add up.
Lapera: Definitely. So, before I forget, potentially, you're filling out your 401(k) paperwork, and you might get to a point where it's like, do you want a Roth 401(k) or a regular 401(k)? What does that mean?
Caplinger: Basically, the 401(k) world recently caught up to the rest of the retirement world. We've had this thing call the Roth IRA for about 20 years. Basically, what it does is flips the usual retirement account scenario on its head. It used to be, the only kind of retirement contributions you could make, you would get an upfront tax deduction for the contribution that you make, but then you would have to pay taxes on the money when you took it out in retirement. That's great for somebody who's high-income right now, because their tax rates are really high, and they're losing a lot of it to taxes. They would love to get that write-up. But for people who are just starting out in a low tax bracket, usually they're just better off if they pay the taxes now, if they can get the promise of tax-free treatment later on when they take the money out in retirement. That's exactly what the Roth option in the 401(k) does. Not every employer who offers a 401(k) will have that Roth option in there, so don't be surprised if your employer doesn't offer it. But if it does and you're just starting out, take a really close look at that Roth option, because a lot of the time it's going to be the best long-term solution for you with your finances.
Lapera: I know with a regular IRA, there's income limits with who can contribute to it. Is that true of a Roth 401(k) as well?
Caplinger: No, it's not. That can be really helpful, if you're one of the fortunate few who comes out of school with a relatively high salary, then you're in a position where you might not be able to do a Roth IRA, because like you said, those IRA contribution limits apply. There's no income limit for Roth 401(k) contribution, so that gives you the opportunity to get into that Roth option in a way that can really help you out.
Lapera: Definitely. And not that it makes much of a difference to you -- you should make your own decisions based on your life -- but, I have a Roth 401(k), and I love it.
Caplinger: There you go.
Lapera: We talked a little bit about student loans, taxes, 401(k), all the boring adult stuff that you're hoping to put off, so one more boring adult thing, which is, you should really, really start building an emergency fund if you don't have one. An emergency fund is great for unexpected expenses like, all of your tires got punctured all at one time. I don't know what you were doing, it was probably a bad idea, but there you go, you have your emergency fund to pay for it, you don't have to scramble and worry about it, you don't have to take money out of any of your retirement accounts to pay for it. Having this emergency fund is a pretty essential component of being an adult. And all of this may sound very overwhelming, but there are some things you can do to make it easier on yourself. The first and foremost is make a budget and stick to it. Budgets don't work if you don't actually make them work. Then, the other thing you can do, which I mentioned earlier, is set a certain amount of your paycheck to automatically deposit into your savings or your retirement account, so that you can slowly start building these things up. Like I said, you won't even notice the money is gone, because it will never have hit your bank account in the first place. Hopefully, you're lucky enough to be working at a job that pays you enough to do that. If not, hopefully one day in the future, you will be, and in the meantime, you can always budget and try and find a little bit extra. Dan, do you have any last-minute advice here, end-of-the-show advice?
Caplinger: Yeah. Don't let this sort of thing overwhelm you. Part of the reason why employers get all this paperwork done all upfront is so you don't have to worry about it. Once you get it done once and get it set up well, it can keep going pretty much automatically for quite a while, and that's what you want to do. It's worth taking the time upfront to make sure you understand what's going on. But, once you do that, you should have the confidence, like, "Hey, I've set things up well, it's going to work for me for now. Sure, in the future my life will change and I'm going to need to take a closer look at it again. But, for now, I have everything set up the way I need to. Now I can focus on doing my job, doing it well, getting a good start to my career."
Lapera: Definitely. That's great advice. I think that's it for today. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at firstname.lastname@example.org, or by tweeting us @MFIndustryFocus, and let us know what you would like to hear about next. Listeners, Dan and I will eventually be doing a personal finance mailbag, so if you have any of those types of questions -- keeping in mind that we cannot offer personal advice -- you're more than welcome to write into us, and we'll hopefully answer it on that show.
Caplinger: Keep them coming.
Lapera: Yeah, definitely. See how excited we are? We're full of excitement. I would like to thank Austin, our magnificent producer, whose name I swear I know. Austin, on a scale of 1 to 10, how much do you wish you had heard this podcast when you graduated?
Austin Morgan: Definitely. But, I did max out my 401(k) as soon as I get hired.
Lapera: Whoo! Excellent. And, also, congratulations on the new puppy.
Morgan: Thank you.
Lapera: If you send me a picture, I'll totally tweet it out over the Industry Focus Twitter so all of you listeners can see it. All right, everyone, thank you so much for joining us, and I hope you all have a great week!