If you're among the estimated 1.86 million people who graduated, or will graduate, from college this year, congratulations! As graduates, you're about to enter the next phase of your life, and a big part of this is starting to plan for your future. As you start your career, here are three things you need to know about saving and investing that can help you get started on the road to financial freedom.
Your 401(k): Don't leave free money on the table
Chances are that your first job in your career field will come with an employer-sponsored retirement plan like a 401(k). And most plans have some type of employer matching program. For example, a common limit is a match of 100% of your contributions up to 6% of your salary. So if you earn $50,000, your employer will match your first $3,000 of retirement contributions dollar for dollar.
Under no circumstances should you contribute less than your employer is willing to match, even if it seems like a lot of money you won't be getting from your paycheck. The employer match is part of your compensation package, so not taking advantage of it is like giving away a part of your salary.
Sadly, this is a common issue, as recent data suggests that 4.4 million Americans don't take full advantage of their employer's match, leaving as much as $24 billion on the table every year.
In fact, the percentage of your salary your employer is willing to match should be looked upon as a minimum amount you should contribute. The IRS actually allows for up to $18,000 in elective deferrals -- your voluntary contribution -- so if you can afford to contribute a few percent more than your employer is willing to match, go for it.
Know your tax-advantaged options
As a new investor, it's important to understand the difference between standard and tax-advantaged investment accounts. When you open a standard brokerage account, your capital gains and dividends will be subject to income taxes.
Accounts intended for retirement savings generally have tax advantages, which are intended to motivate people to save more for retirement. Your 401(k) is an example of a tax-advantaged account. Your contributions are made on a pre-tax basis, meaning that you don't pay income tax on the portion of your salary you choose to contribute. And you won't have to pay annual capital gains or dividend taxes -- just when you withdraw the money.
For investors who want the freedom to invest in any stocks, bonds, or mutual funds they want, an individual retirement arrangement, or IRA, might be a good idea for you. IRAs come in two varieties -- traditional and Roth, and the basic difference is the tax treatment. A traditional IRA works similarly to your 401(k) in that contributions might be tax-deductible now, but future distributions will be subject to tax.
A Roth IRA works in the opposite way. You can't deduct your contributions, but your withdrawals in retirement are tax free. It basically boils down to a choice of when you'd rather pay your taxes -- now or later.
Both traditional and ROTH IRAs are great tools to save for retirement, and allow for up to $5,500 in contributions for the 2015 tax year.
Know what your biggest asset is
As a young investor, the most important thing you need to know is that your biggest investing advantage is time. The early years of your investing career are the most important, and any small amounts of money you can set aside early on in your career could grow into large sums when allowed to grow for several decades.
Consider this example. Let's say that you're 25 and plan to work until you're 65, so you're 40 years away from retirement. And you have two hypothetical choices – you can invest $10,000 now, or invest $20,000 at age 40, and then allow your money to grow until you hit retirement age. Which do you think would produce the most value in the end, assuming you average a 7% rate of return on both?
The answer may surprise you. The $20,000 you invest at 40 would grow into $108,500 by the time you hit 65. However, the smaller $10,000 investment you make at 25 would grow to $149,750, simply because it had more time to grow. That's the power of compound gains, and why it is so important to start as early as possible.
To further illustrate this point, consider this chart showing how $10,000 could grow over time.
The takeaway: early and often
Simply put, if you're about to start your career, the most important thing for you to realize is that the early years are actually the most valuable to your long-term financial success. Not only do you have decades in front of you to take advantage of compound gains and the tax advantages to which you're entitled, but now is the best time to develop solid saving and investing habits that will last the rest of your life.
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