6 financial terms every 20-something should know
March 06, 2015
Financial advisers, it seems, don't always agree. For instance, there seems to be some difference of opinion regarding when exactly young adults should be expected to understand and manage their own finances.
"If they are old enough to drink alcohol, get married and drive a car, they should also be old enough to learn to manage their finances," says Douglas Goldstein, CFP, investment adviser and author of "Rich as a King: How the Wisdom of Chess Can Make You a Grandmaster of Investing."
Meanwhile, Andrew Meadows, consumer and brand ambassador at Ubiquity Retirement + Savings, gives young adults a pass on financial self-sufficiency until they are done with their education and entering the workforce. "It's when you get your first real job," he says.
While Goldstein and Meadows may have slightly different opinions about when young adults should be financially independent, both agree 20-somethings need to be able to speak the language of money to be successful. Here are six financial terms every young adult should know before striking out on their own.
1. Overdraft protection
When you get a job, you'll likely need a checking account, if you don't already have one.
"The various aspects of banking can be a bit confusing and difficult to understand at the beginning," Goldstein says.
Overdraft protection is one example of a confusing bank product. It may sound like a benevolent service offered by banks, but it can actually cost you a lot of money. Overdraft protection doesn't protect you from overdrawing your account. Instead, it allows you to do so for a price.
For example, if you have a zero balance in your account and try to use your debit card, the bank will allow the charge to go through if you have overdraft protection. You are then charged a fee for the privilege. Without overdraft protection, your card will be declined. This can be embarrassing, but it may save you money in the end.
2. Compound interest
Ubiquity Retirement + Savings offers retirement accounts geared toward young business owners, so Meadows has had plenty of experience talking to those new to investments. While all investing concepts can be tricky to understand, he says millennials seem to have particular difficulty with the idea of compound interest.
"It seems unreal," Meadows says of the online graphs and calculators that show how a small amount invested now can turn into a big number by retirement age. The reason young adults may have trouble believing the numbers is because they don't understand compound interest, which lets you earn interest on interest.
In other words, a 10 percent annual return on a $100 investment will give you $110 at the end of year one. In year two, you earn interest on your $100 initial investment plus the $10 interest, for a total of $121 in year two. In this example, by the end of 10 years, your investment will have grown to more than 2.5 times your original investment without your depositing another cent.
"It's not magical," Meadows says. "It's a mathematical fact."
3. Defined contribution plan
When you accept your first real job, it will hopefully come with some sort of retirement benefit. Typically, that may be either a defined contribution plan or a defined benefit plan. You may also hear the term deferred compensation used in conjunction with both of these. "We thrive on confusing terminology," Meadows says of the retirement industry.
A defined contribution plan means your employer will put a certain amount of your salary into a retirement account for you, usually a 401(k) plan.
4. Defined benefit plan
The second type of retirement plan you could get, if you're lucky, is a defined benefit plan. These are commonly referred to as a traditional pension plan.
With these plans, your employer says they will pay you a specific (i.e., defined) amount after you retire. The amount is often paid monthly and is calculated as a percentage of the income you earned during your final years with your employer.
5. Asset allocation
Those who end up with a 401(k) at work or open their own individual retirement account (IRA) will need to contend with something called asset allocation. This term simply means deciding how best to invest the money you put in the account.
When it comes to asset allocation, there are several theories regarding how best to split money between stocks, bonds and cash options. However, Meadows says young adults shouldn't worry too much about asset allocation up front.
"Don't over-analyze," he says. "The best advice is to just start saving period."
Retirement benefits aren't the only thing that can confuse new workers. They may also find the array of withholdings from their paycheck to be baffling.
One of the largest numbers you might see taken off your income is FICA. An abbreviation for the Federal Insurance Contributions Act, FICA levies a 15.3 percent tax to pay for Social Security and Medicare benefits.
Of that amount, 2.9 percent goes toward Medicare while 12.4 percent is earmarked for Social Security. In 2015, the Social Security portion is assessed on only the first $118,500 you earn for the year. For payroll workers, the FICA tax is split between workers and their employers.
Embracing financial adulthood
Those are a few of the financial terms you should know before heading out into the workforce. If they are new to you, you're probably in good company.
"Many kids graduate high school without being able to read a bank statement, and that's pretty sad," Goldstein says.
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