So, you recently picked up your college diploma and settled in at your first job. Congratulations! You now have plenty of newfound freedom and money in your pocket—or do you? If you’re like most young workers, the actual dollar figure you take home—after reductions for a host of taxes and workplace retirement savings programs—can be a bit of a shock.
The comforting news is that virtually every worker is in the same boat and faces competing financial obligations. From paying rent and saving for retirement to paying back student loans and, yes, having a life, knowing where your money goes and how it is spent is a critical component of becoming a smart investor.
For many young investors, navigating a myriad of taxes, debt, and other obligations is not uncommon. But the more you know about these issues at the beginning of your work life, the better prepared you will be to start off on the right foot. Here are some key money issues to be aware of as you seek to make the most of your paycheck and build your financial life.
1. Understand taxes and deductions.
Many expenses compete for a portion of your paycheck. Here are some taxes and deductions to keep an eye on.
Payroll tax. If you have a job, your employer will generally withhold a portion of each paycheck to pay state and federal income tax, based on your income tax rate, as well as FICA, which is the government program that funds Social Security and Medicare. When you complete your tax return at the end of the tax year, you’ll learn that you either overpaid or underpaid your total taxes due for the year. Depending on the outcome, you'll either receive a refund from the IRS or be obligated to send them a check for what you owe.
Self-employment tax. If you work for yourself—perhaps as a freelancer or business owner—you must pay self-employment tax, which accounts for both the employer's and employee’s (or employees') respective shares of FICA. If you don’t have an employer to withhold your taxes, you may need to file estimated taxes quarterly with the IRS and your state treasurer. For more information, visit the IRS Self-Employment Tax page.
Standard versus itemized deductions. All taxpayers can deduct a set amount from their taxable income on their tax returns. It's called the "standard deduction," and for tax year 2015 it's $6,300 for individuals and $12,600 for married couples who file taxes jointly. Alternatively, you can choose to itemize and claim the various itemized deductions for which you’re eligible—for example, for mortgage interest, charitable contributions, and business use of your car.
Student loan interest. Even if you choose the standard deduction, you may still be able to deduct the interest you paid on any student loans. You may be eligible for the deduction even if your parents make your payments. For more information, read IRS Publication 970, Tax Benefits for Education.
Investment tax. If you own any stocks, bonds, or other investments, you may need to report interest, dividends, and capital gains and losses when you file your tax return. The IRS 1099 tax forms that you receive will inform you of any investment income you need to report when you file. For more information, see IRS Publication 550, Investment Income and Expenses.
Filing your income tax return. You might be filing your first return for which you are not claimed as a dependent of your parents. Fortunately, it’s typically pretty easy. The key is to stay organized. Early each year, you’ll receive your W-2 forms (listing any employment income you earned during the previous year) and 1099 forms (which include income from self-employment and other sources). Create a simple system for collecting and categorizing these and any other financial documents.
If you have all the necessary documents on hand when tax season rolls around, it should be easy to enter information into the appropriate forms—either on paper or using an online tax software program. If you want someone to help you and you don’t mind paying a fee, you can take all your paperwork to a certified public accountant. Another filing option is the VITA program (Volunteer Income Tax Assistance), that offers free tax help, generally available to people who make $53,000 or less, persons with disabilities, the elderly and taxpayers who speak limited English and who need assistance in preparing their own tax returns. IRS-certified volunteers provide free basic income tax return preparation with electronic filing to qualified individuals. No matter how you do your taxes, it’s smart to start early to avoid last-minute stress.
2. Start saving for retirement.
Retirement probably seems far away, but setting aside even a small portion of your income now can make it much easier to build the savings you’ll eventually need to retire. If your employer offers a retirement plan, sign up for it. If you have a 401(k), 403(b), or 457 plan and your employer offers a matching retirement contribution, take advantage of it. The matching contribution is like getting free money. Plus, you get the potential benefits of tax-deferred growth and compounding returns.
The sooner you start, the more potential your money has to grow. Even if you are in your 30s or 40s, it's not too late. When you reach age 50 or older, you may be able to add extra "catch-up" contributions to your workplace savings plan.
3. Deal with debt and build good credit.
It’s not unusual for college students to graduate with significant credit card and/or student loan debt. If you’re in this situation, consider paying down high-interest credit cards. But try not to let go of your retirement savings plan through your 401(k). At least contribute enough to get the company match. Once you’re comfortable with a savings plan and payments that you can afford, begin to tackle college debt reduction. If you’ve avoided taking on debt so far, take care not to fall into it now. You can do that by listing all your monthly expenses—easy if you pay your bills online through your bank’s Web site—and then comparing them with your monthly income.
Begin paying off student loans. Most student loans allow a brief grace period following graduation, during which no payments are due. Once that period is up, however, you’ll need to begin payments unless you qualify for a deferment because of unemployment or health problems. Federal loans offer several repayment options, including an income-based option that may enable you to meet the minimum payment—even if your first post-college job does not offer a substantial salary.
Build your credit score. Building good credit can help you qualify for low-interest loans, secure an apartment, get a job, qualify for a mortgage, and help create the life you want to live. The most important element credit agencies consider when figuring your credit score is your payment record. So whatever you do, don’t ignore the payment-due letters you receive for your student loans, credit card debt, or other liabilities.
If you have trouble making your minimum payments, call your creditors and explain your situation. The company might be able to work out a payment plan that you can live with. If you don’t pay the bills, you’ll start getting calls from collection agencies—and this will likely hurt your credit score, which might make borrowing in the future more difficult and more expensive.
4. Develop a spending plan.
Most banks and credit card companies make it easy to access your spending records online, making budgeting easy. You can use your spending history to make informed estimates of your future expenses. With this information in hand, you can prioritize your goals and make sure that you’re spending money on things you really care about, while reducing unnecessary purchases.
It’s always tempting to put off saving until later. The trouble is, later never comes—and for many people, saving never gets easy. But there are ways to make it routine. If you have direct deposit, arrange for your bank or brokerage account to direct a portion of each paycheck into a savings account. If that money isn't in your checking account, your budget will automatically adjust. You probably won’t feel the difference—and you’ll start building a stash for a rainy day.
Create an emergency fund. At some point, you’re likely to have an urgent need for cash, whether your car breaks down, you get laid off, or you need to move for a new job. In all cases, you need a financial cushion to fall back on. During your first post-college year, gradually build at least three months' worth of living expenses in an easily accessible savings account, and touch it only when absolutely necessary.
Graduating from college entirely revamps your financial situation: You have a new degree of freedom to create the life you want to live, and you also have new financial responsibilities, from taxes to loan payments.
Building good financial habits is a critical part of creating the life you have always dreamed of living. By staying organized, saving for retirement, reducing debt, building credit, and sticking to a budget, you’ll be able to make money work for you instead of against you.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917