Financial Planning Suggestions for Young Adults
As I write this in late spring, this is the season when graduating students are transitioning from the academy to employment. Many financial matters that may have previously been taken care of, or at least “backstopped,” by parents are now their own to address. If you are a newly minted graduate turned employee, what are some money things to be mindful of? That is the topic of today’s post.
Determining your net worth is a snapshot in time that adds up all the things that you own and then subtracts all the debts you owe. It is a useful gauge to assess your financial progress.What you own may not be very much. Your bank account, smartphone, laptop, some furniture, and maybe an inexpensive car. As for debts, like many students you may have a student loan to deal with that is larger than all the things you have that are worth anything. If you own a car, you may also have some debt there, too.
The reality is, as this example shows, you may have negative net worth, which is to say that you owe more than you own. I wouldn’t be too worried about that situation. As a young person, much of your net worth is potential and is connected to your ability to earn an income. In other words, you have human capital, not financial capital. Eventually, though, your ability to work, earn an income, and save some of those earnings will shift some of that capital to the financial side. As your income exceeds your expenses, your cash flow that is available for savings will go toward increasing your net worth.
It is important to get cash flow right. Early in your career your income may not be very high, so staying on the positive side could be tough, but it will pay off.
Just like with net worth which has two basic components, what you own and what you owe, so also does cash flow. There is income and there are expenses.
Income is most likely going to come from one source: employment. For this post, I will not address the self-employed.
There will be deductions from your income before it gets into your hands. These will include income tax, contributions to the Canada Pension Plan (CPP), and contributions to Employment Insurance (EI). These are unavoidable deductions, but CPP and EI are capped.
Other items that may be deducted from your pay may include contributions to your employer-sponsored pension plan or group benefits. Not every employer offers these benefits, but they can be quite comprehensive.
Beyond expenses that come off your paycheque before you even see it hit your bank account are the usual costs of living: food, clothing, car expenses or public transit, rent, utilities like heat, electricity and water, and your cellphone bill. You may also have a few insurance costs. And, if you have student and car loans, and/or debt on a credit card, you’ll have to pay those, too.
There are also some of the fun things of life that you have to pay for: vacations, entertainment, going out, etc.
Finally, don’t forget savings. You probably don’t think of savings as an expense. However, if savings consist of money that is not available to you for your costs of daily living, it makes sense to think of it as an expense.
Savings can be for the short term, medium term, or long term. In the short term might fall something like the purchase of a guitar, something you can save for within a few months. Medium-term savings might take a year to five years or so to complete. Possible reasons for saving in this category include a wedding, a new car, or perhaps the down payment on a home. I would consider long-term savings to be primarily concerned with saving for retirement.
Finally, in savings, it’s valuable to have a bit of money set aside for contingencies, that is, unexpected expenses. Having that cushion there will help reduce stress in your financial life.
This example is perhaps the ideal arrangement. A total cash flow of zero means that every dollar of income and expenses is identified and purposeful. In real life, that arrangement is seldom realized, but if you err, please do your best to err on the positive side, with money left over.
When your cash flow includes room for savings, you need to start thinking about what to do with that money.
Short Term Savings
I wouldn’t necessarily stay away from the online banks for savings horizons of up to five years, either. Depending on how certain your timeline is, you may want to lock in some of the money by purchasing Guaranteed Investment Certificates (GICs) if you can get a meaningfully higher interest rate. You may want to put this money into a more tax-efficient account, though, like a Tax-Free Savings Account (TFSA). If you are 22 this year, you are in your fifth year of eligibility to contribute to a TFSA, which means you have $29,000 in contribution room.
Here’s where the investment questions really come into play. Long-term saving is often money that is earmarked for retirement. Retirement savings can come in a variety of forms. Account types that you can use for yourself include the Registered Retirement Savings Plan (RRSP), the Tax-Free Savings Account (TFSA), and the non-registered account. See more in the section on Retirement Planning.
To reduce the risk of your investments it’s best to diversify across multiple assets. Don’t just invest in a single stock. That is the benefit of mutual funds or exchange-traded funds (ETFs); you are immediately diversified.
Risk Tolerance, Time Horizon, and Investment Objectives
Are you open to taking risks or are you cautious? Do you have stable employment with a regular income or is your employment precarious with an income that fluctuates? When do you need the money from these investments? In less than five years? Greater than 10 years? Are you saving for a house that you want to buy in three years? Or are you saving for retirement that is more than 30 years away? Answers to these questions will help you decide how much risk you can take with your investments.
These are all challenging questions and sometimes the answers are not always clear. Many like to invest the money themselves using an online or discount broker, but unless you have good guidance, it may be better to use a so-called robo-advisor rather than trying to handle it on your own. Still others may wish to go with a mutual fund company.
Should You Even Invest?
This whole section could be perceived as an instance of begging the question, assuming without justification that investing is something you should do. If you have debt that charges a high-interest rate, like the 20% or so charged on a credit card, forget about long-term investing until that debt is gone. You may still want to set aside some money every month to establish a contingency or emergency savings fund to cover unexpected expenses, but when you are paying out more in interest charges than you can reasonably get in investment returns, don’t bother.
Insurance and Risk Management
You may never have had much in the way of insurance before. If you went to a post-secondary institution, your school may have required you to pay for a group student plan or provide proof of coverage through your parents. However, if you are no longer a student, you are on your own.
You don’t buy life insurance to protect yourself. You buy it to protect others against the possibility of your premature death. If you are not in a relationship, if no one is dependent on your income for support, life insurance is not a major concern. Nevertheless, you may have life insurance coverage through your employer. Typically, the insurance coverage would be equal to your annual salary.
Imagine a situation in which you fall ill or are injured, resulting in you no longer being able to work for an extended period. How will you support yourself? For most young single adults, this is a much more likely event than your premature death. Disability insurance is therefore much more important to consider. Again, your employer may provide this for you, or you may want to purchase this form of protection privately. If you pay the premium, whether through a payroll deduction or private purchase, the disability payments are tax-free. If your employer pays the premium, then you are taxed on the benefit. If there is only one kind of insurance for which you are prepared to pay, then let it be disability insurance. Personally, I used my former employer’s group disability policy for more than two years, so I appreciate its value.
Critical Illness Insurance
You buy this form of insurance if you want to protect yourself against diseases like cancer, stroke, heart attack, and depending on the policy, potentially many other diseases as well. This may seem like an unlikely need for young people, but this kind of thing happens. I would not suggest to you that it is as important as disability coverage, but you may wish to consider it. Your income and ability to cover the premium while still achieving your other financial goals would be an important consideration here.
Supplemental Health Insurance
This is typically a benefit provided by your employer. While insurance companies will advertise these sorts of benefits as being available privately, if your employer does not offer this benefit it is generally better to “self-insure,” which means you pay for it yourself. I hesitate to sound like a nagging parent, but it is important to get your teeth cleaned and checked regularly.
There are not many opportunities to reduce your taxes as an employed person. To the extent there are, the opportunities often are addressed through investment choices, particularly account choices.
Registered Retirement Savings Plan (RRSP)
Contributions to your RRSP result in a tax deduction. Investment income within the RRSP is not taxed. It is only when you withdraw from an RRSP that you pay tax, and with proper planning, you will pay less tax in retirement than you did while working.
Tax-Free Savings Account (TFSA)
There are no tax deductions for contributing to a TFSA, unlike the RRSP. However, investment income within the TFSA is not taxed. Withdrawals from a TFSA are not taxed either. This is one of the best and most flexible investment account types for retirement savings if you are at the lower end of the income scale. It is also probably the best account for medium-term savings, too. Of course, someone in a high-paying profession may still prefer to save in the RRSP even if they are still in their early-to-mid 20s.
There are no tax deductions or tax sheltering in this type of account. However, income from eligible Canadian dividends benefits from a special dividend tax credit and capital gains from an investment are also taxed at preferential rates.
This is rather difficult to think about when retirement may be 40+ years into the future. Government support systems may change by then; you will have changed by then; retirement itself may become an out-of-date concept given steadily lengthening lifespans.
For now, my best recommendations are to recognize that there may very well be a day when you are no longer able to earn an income and plan accordingly. Some elements of that plan include:
- Considering how long you are likely to live;
- Saving and investing now for your future;
- Considering careers with good pension benefits;
- Paying off your debts (e.g., mortgage) by the time you get into your 60s.
There are multiple account types available to save for your retirement, but some depend on your employer.
Employer Pension Plan
Although Defined Benefit pension plans are becoming scarce, they are still a possibility, especially if you work in the public sector. These are often unionized positions, and the pension plans are among the largest in the country. Typically, both you and your employer pay into the plan. At the end of your career, when you retire, your pension will take the form of a regular monthly payment, a defined benefit, for the rest of your life. The pension plan has taken on the responsibility of managing your contributions and the contributions made on your behalf to generate the necessary income for you. Your savings, your contributions, come off your paycheque and you do nothing else. No investment decisions are necessary.
The more common Registered Pension Plan is a Defined Contribution Plan. You contribute a portion of your pay, and your employer matches it, perhaps equal to the same dollar amount you contribute or according to some other arrangement. The contributions are defined but the payments in retirement are not. Furthermore, you have a decision to make as to how you want your pension money invested.
Pension plan contributors are usually given a variety of choices. The default may be a so-called target-date fund, that is, a fund that has most of its assets in more aggressive investments when you are young but slowly gets more conservative as you get older. The decision is made once when you are hired and then you just leave it alone as it will adjust for you over time.
Similar arrangements are available for group RRSPs that are sponsored by your employer.
Another employer-sponsored retirement savings arrangement is the Deferred Profit-Sharing Plan (DPSP). Only the employer can contribute on behalf of the employees, and often the contribution is made using the shares of the employer’s business. In other words, no investment decisions are either necessary or available until you leave your employer. In that sense it is a long-term savings plan for you, but not by you.
Registered Retirement Savings Plan (RRSP)
This is the most commonly talked about retirement savings plan mentioned in the general public. Some speak ill of it because, while they like the tax deduction available when contributing to the plan, they don’t like the tax they have to pay when they make withdrawals in retirement. Beginning in the year your turn 72, withdrawals become mandatory.
RRSPs are personal plans; they are approved by the government, but they are not mandatory. Pension plans may be an effective substitute for RRSPs, and, if you have a workplace pension plan, the contributions into the plan will reduce the contribution room you have available for your personal RRSP.
Without any other pensions or group RRSPs to introduce a Pension Adjustment on your T4, you may contribute up to 18% of your earned income into an RRSP. On $50,000 of annual earned income that works out to $9,000.
There are two great benefits of an RRSP. First, you get a tax deduction for each dollar you put into an RRSP. Second, there is no tax on any of the interest, dividends. or growth while in the account. You pay tax only on the withdrawals.
This arrangement makes the RRSP a bit tricky, though. If you are just beginning your career, your income is not likely that high. It may be wiser to wait until you are earning more before you start putting money away in this plan.
As an aside, people often speak of buying RRSPs. That’s not what happens. You open an RRSP and put money into it. Then you must decide about how to invest in it. Think of the RRSP as an investment or savings bucket with unique tax characteristics.
Tax-Free Savings Account (TFSA)
If your income is not sufficient to warrant the purchase of an RRSP, then consider a TFSA. Like the RRSP, you can invest in a variety of products, from a simple deposit account earning almost no interest to a wide variety of stocks and almost everything in between. The tax characteristics of a TFSA are as follows: First, you do not get a tax deduction when you contribute to it. Second, like the RRSP, the investments grow tax-free while in the account. And third, you do not pay any tax when you withdraw from it. This combination of characteristics makes the TFSA especially good for those on the lower end of the income spectrum. Unlike the RRSP, you can also withdraw from your TFSA and contribute the same amount to the account the next year without losing your contribution room. In recent years, the contribution limit has been set at $6,000 per year for those aged 18 and over.
For the most part, this type of account will not be relevant to a young adult since there aren’t any tax advantages, except for one, and frankly, this is an advantage you don’t want to need. If you sell an investment for more than your cost, you pay a tax on the gain, referred to as capital gains tax. This tax is currently at 50% of the rate you pay for employment or interest income. However, investments can lose money. If you sell an investment for less than your cost, you are allowed to claim a capital loss. This loss can be used to offset gains, reducing the tax you owe. In a TFSA or an RRSP, because there is no taxation of investments in the account, gains and losses have no tax consequences.
Estate Planning and Legal Aspects
Estate planning involves drawing up a legal document – a will – that assigns someone to take care of distributing your assets according to your instructions after you die. If you don’t have any assets and/or there is no one that you would like to make sure gets your assets, then a will is not as crucial compared to a situation in which you have a spouse, children, and significant assets. A simple will can do the job. Two online will companies that you may wish to consider are Willful and Epilogue.
One aspect of estate planning that may be more relevant is how to deal with your social media accounts, your digital assets, so to speak. Providing a list of accounts and passwords to the person you appoint to be your executor has taken on increasing importance.
Power of Attorney
As mentioned before disability is a much more likely circumstance for a young person than is death. Correspondingly, granting someone power of attorney for you has potentially much more value for you right now than does a will.
Power of Attorney for Property
If you were to fall ill or become disabled, even if only temporarily, you may need someone to act on your behalf. On the financial or property side of things, your attorney may have to pay your bills or engage in other kinds of routine financial transactions on your behalf.
Power of Attorney for Personal Care
If you cannot take care of yourself, you may also need an attorney to make decisions about your health care, housing, or food, to name a few concerns here. This is the Power of Attorney for Personal Care.
Different provinces use different terms and/or have a different range of responsibilities involved. The closest equivalent in several provinces is an advance health care directive or a similarly worded variation. BC provides for a representation agreement.
The Plan Well Guide
A great tool, and something that could be completed to supplement instructions for your personal care, is the Plan Well Guide. This service helps you lay out in clear terms the treatment you would like to receive if you became seriously ill. This is something you can complete online. If you ever were in a situation in which you were unable to make your health care wishes known, this guide would help the people close to you know what you would want and provide instructions to the doctors for your care.
The above sections represent the six planning categories for a comprehensive financial plan. Not all of them will be of equal relevance to you, but each will probably have its time. Take what is valuable to you now and consider the rest for a later time.
This is the 102nd blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.