Crunching the Numbers on Post Graduate Life
Post Graduate Life
You’ve just graduated and you’re excited about starting a career and being independent from your parents. The problem is being independent from your parents also means being financially independent from them. You may have student loans rolling in and the pressure of finding a job so that you can pay them. So where to start first? What do you prioritize with the income that you will be making after finding your job? Let’s take a look at the numbers after making some assumptions.
Income, Taxes and Expenses
Let’s say you find an entry level job that pays an annual salary of $50,000 per year (2,000 hours @ $25 per hour). Let’s also assume that you’ve racked up $50,000 in student loans which have just surpassed the grace period and are charging you an annual interest rate of 8%. Your student loan interest rate may be higher but if you refinance (and have decent credit) you should be able to get in the 6-8% range.
Next lets examine what your true after tax take home income is based on that $50,000 salary. The U.S. Federal tax is progressive meaning it goes up as your income increase (Unless you’re Donald Trump). Therefore, based on the 2017 tax table you would be taxed as follows:
2017 U.S. Income Tax Table
$0 to $9,325 @ 10%
$9,235 to $37,950 @ 15%
$37,950 to $91,900 @ 25%
Before doing the calculation your taxable income would first be reduced by your personal exemption ($4,050) and Standard Deduction ($6,350) leaving you with taxable income of $39,600. Also, keep in mind these are rough calculations and always refer to a tax professional for your individual situation.
Based on the marginal tax rates you would pay a total of $5,638.75 in Federal Tax. Tack on another 5% for State Tax (could be different depending on state) of $1,980 and an additional 7.65% for Social Security and Medicare of $3,825. The total tax paid of $11,443.75 means you pay an effective tax rate of 22.89%.Therefore, your true take home income is $38,556.25 or $19.28 per hour.
Next lets calculate your payment on your student loan. Lets assume the $50,000 student loan debt is paid monthly on a 10 year payment schedule; at 8% compounded monthly your payment would be about $606 per month.
Based on the 2,000 hour annual work schedule you will work on average about 168 hours per month. Based on your after-tax take home income (that is 168 x $19.28 or $3,238.73) your student loans have already eaten into 18.71% of your take home pay.
That leaves you with $2,632.73 before any rent, utilities, car insurance, health insurance, cell phone, food, discretionary spending, etc. I’m not going to break down each individual expenditure but if you are disciplined and frugal you should be able to stick to a budget of $2,000 for mentioned lifestyle expenses. It’s tough but doable.
Start an Emergency Fund
So what to do with the net income of $632.73 per month? First thing you NEED to do (and it sounds trivial) is establishing an emergency fund. You emergency fund should be at a minimum 3 months worth of living expenses. In this case that would mean having about $6,000 in a savings or checking account that is readily available to pay for the lump-sum unexpected expenses you will inevitably have. As you establish yourself and your career you should consider increasing your cash reserve to 6-12 months worth of living expenses.
A credit card really should be a secondary reserve for true emergencies. Avoid credit card debt like the plague and pay off your balance in entirety each month. Don’t be afraid to pay for everything with a credit card as it helps establish a good credit history and can provide cash back rewards; just make sure you live within your means and pay the entire balance each month.
Employer Sponsored Retirement Plan
Simultaneous to establishing an emergency fund is reviewing your employer sponsored retirement plan. The most popular plan offered by private companies is a defined contribution plan such as a 401(k). Typically, the employer will match a percentage of your salary as long as you contribute at least the same amount.
For example let’s say the employer matches 4% of your salary; that means as long as you contribute 4% ($2,000) over the entire year your employer will also contribute $2,000. Foregoing $167 a month from your net income of $632 you will receive an extra $2,000 for doing nothing extra. This is essentially free money you need to take advantage of. At a bare minimum you should be contributing enough to get the employer match.
Individual Retirement Account (IRA)
As your salary grows and your debt decreases you should strive to save 10% of your salary and in addition consider taking advantage of an individual retirement account (IRA). And if you really want to be a hero any additional savings could be invested in a taxable brokerage account. Investments in a taxable brokerage account could be earmarked for shorter term goals such as a down payment for a house.
A big complaint I hear from people our age is that they don’t want to lock up their money for 40+ years in a retirement account. This is where the flexibility of utilizing a Roth IRA comes into play. With the Roth IRA you are using after tax savings meaning money you have already paid tax on.
This means that any growth that takes place within the account is not taxed when taken out after age 59 1/2. Additionally the Roth IRA allows for exceptions such as penalty free withdrawals of up to $10,000 for first time home buyers. When you are in the 15-25% marginal tax bracket utilizing the Roth IRA or Roth 401(k) can have substantial benefits especially since you will most likely be in a higher tax bracket down the road. Having a non-taxable investment bucket to compliment your other savings will be extremely useful later in life.
This may seem like a lot to take in but the main point is that even though retirement is long ways away by foregoing small amounts of income today you’ll be taking a huge burden off of your shoulders. As you progress in life you may eventually have kids whose education you will want to save for as well as other obligations that will make saving for retirement difficult.
My final thoughts on prioritizing paying down debt vs. saving and investing: If you are paying an interest rate of 8% that means you must earn at least 8% in an investment account to justify the opportunity cost of foregoing to pay down debt. The main difference is that by paying down debt you are guaranteeing an 8% return whereas an investment account is anything but guaranteed.
In fact, 8% return is about what you would expect to earn from a moderate 60/40 portfolio over the long run. So does that mean you should focus solely on paying down debt? Two reasons why I wouldn’t:
- Number one is discipline and the idea that if you don’t develop the habit of saving and/or investing then those few extra dollars you do have will most likely just be spent on discretionary lifestyle expenses
- Reason number two is timing; by staying disciplined and persistent in your investment purchasing habits you will be buying into at market at different times which will allow for potentially greater returns in the long run. Volatility is the accumulators friend.
Remember to plan for tomorrow while still living for today.
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