If you are one of the lucky grads switching from full-time student to full-time employee this graduation season, congratulations. You have made a significant investment in yourself, and you are seeing it pay off. You may have already mentally spent your first paycheck, but taking a moment to plan for your financial future, as unglamorous as it may sound, is worth doing right away. Getting on the right track soon will save you from pitfalls and bad habits that could derail your net worth down the line. You worked hard to earn that new salary—here are five tips to make it work for you.
1. Take advantage of your new benefits
You should never turn down opportunities for your employer to match your retirement savings—a dollar–for-dollar match is a 100-percent return on your money, pretax. Make sure you have enough cash to function but then max out your employer contributions.
2. Get rid of bad debt
The decision to take on debt depends partly on your risk tolerance, because debt increases the risk to your personal wealth. Regardless of how risky you're feeling, you should do your best to eliminate bad debt. Bad debt is money you owe that incurs higher costs than you can expect to earn on your investments. For example, if you're paying 16 percent interest on your credit card and have a certificate of deposit at the bank yielding a low return (it will surely be less than 16 percent), you are not earning enough on your investment to cover your interest expense.
Now, what about student loans? That depends—student loan debt that is privately financed with high interest rates should be paid off quickly. You can justify spreading out the payments for federally subsidized debt while building up your cash fund or making additional investments.
3. Build your cash fund
There’s no universal agreement on how much cash to stash away, but half your salary is a reasonable goal. That’s a big number, so it’s something to plan for and work up to. Yes, you need money in case of an emergency, but having a large cash reserve gives you more financial freedom in other areas—including the flexibility to self-insure against non-catastrophic losses (i.e., losses that can be covered with your cash fund). For example, I don’t carry collision insurance on my car, and I never pay for travel insurance because neither one is a catastrophic loss for me. So I self-insure against these losses and internalize the high profits the insurance companies earn on these policies. But if you don’t have the cash fund, you don’t have the financial flexibility to self-insure.
4. Put your salary in context
Before you accept a job offer, it’s important to understand how your cost of living and purchasing power affect your income. Let’s say your new salary is around $100,000. In New York City, that salary gets reduced to around $63,000 after taxes (federal, state, city, and FICA). Consider the cost of living (relative to the average cost of living in the country), and it is more like $29,000. In contrast, look at Wichita Falls, Tex., where after taxes, that salary is more like $73,000. After factoring in a cost of living that’s below the national average, the salary raises to $84,000. That doesn’t mean you should necessarily take the offer in Wichita Falls over New York City (you may build your human capital more through developing connections in New York City) but knowing how taxes and location affect your finances allows you to see the big picture before making major life decisions about where to work and where to live.
5. Invest intelligently
When you invest, look to a combination of treasury inflation-protected securities (TIPS) and index funds. TIPS are the closest thing we have in the real world to a risk-free investment, because they have virtually no default risk and are guaranteed to keep pace with inflation. Index funds are the best means of investing in risky assets such as stocks and bonds because they are more diversified and have low management fees. Additionally, take advantage of all tax-sheltered investing options, such as a 401(k) or 401(3)b, I Bonds, IRAs, and SEP IRAs. After all, it’s easier to build your wealth when you aren't paying taxes on it.
Allan Eberhart is a professor of finance at Georgetown University’s McDonough School of Business who specializes in personal wealth management. He also is the director of the school’s Master of Science in Finance program.