Graduate school is a financially challenging time even if you are fully funded. Your stipend isn’t intended to do much more than pay your basic living expenses. You are likely young and relatively inexperienced with managing money, especially for long-term goals. You’re short on time to learn about financial best practices, and you may even be suffering from analysis paralysis. Investing may be either the furthest thing from your mind or yet another item languishing on your “To Do” list.
I believe that if you fully understood the benefits of investing right now, you would be chomping at the bit to get started. If you have the means, investing for the long term is one of the best possible uses for your money during graduate school. Of course you should cover your basic living expenses and live a little, but you can simultaneously begin building your lifetime wealth. It’s worth starting to invest during graduate school even if you can only put away a small amount or a small percentage of your income. Your status as a graduate student is even an investing advantage in some ways!
Below are four reason why you should start investing for the long term during grad school.
The Time Value of Money
In investing, time matters a ton. There are three key components to increasing your wealth: how much money you invest, what you invest in (i.e., the return you get), and for how long you invest. The first and third are the most important, believe it or not, because they are the most under your control.
Compound interest, or the time value of money, is the magic element that makes investing so powerful. Well, it’s not magic, it’s math – exponential growth. Here’s how compound interest works: Assume that your invested money gives a modest return each year. In your first year, your money grows by that return. In your second year, your money grows again, plus you get growth on last year’s growth. In the third year, you get growth, growth on growth, and growth on growth on growth. This continues (on average) for the entire period you are invested. Growth on growth ad infinitum!
One of the most powerful actions you can take for your net worth is to get the compound interest clock ticking for you as early as possible. Say, for example, that you need to invest regularly over 40 years to fund your retirement. Would you rather start that clock right now or wait until you’re done with your training?
You might think that starting to invest during graduate school is a big sacrifice that won’t amount to much because you won’t be able to save nearly as much now as you will on your future Real Job salary. This is a dire misconception!
Let’s take Tom as an example graduate student. Tom receives a $30,000/year stipend and invests 10% of it every month throughout his five years in graduate school. Over those five years, he contributes $15,000. Given an 8% average annual rate of return (very reasonable for a long-term investment), at the end of graduate school Tom’s account balance has grown to $18,353.49. If we leave that sum of money alone to continue to compound at 8% (no additional contributions), the balance grows tremendously. After 40 years, it has become $398,720.79! That’s an extra $400,000 for Tom’s retirement that he wouldn’t have had if he hadn’t started investing during graduate school.
Ingraining Positive Saving Habits
Incorporating regular long-term investing into how you manage your money during graduate school creates a powerful habit. Not only are you experiencing the benefit of compounding interest on the money you invest during graduate school, but you have created a habit of investing that will carry forward throughout your whole life. In fact, by doing so you have changed your identity to that of an investor!
Investing during graduate school is a sacrifice, of course. But to be honest, it’s going to be a sacrifice at whatever point in your life you start to invest. People always think that it’s going to be easier to start saving later, when x, y, and z in their life has changed; this mindset is not unique to graduate students. Yes, in a few years you’ll have a Real Job’s salary, which will make saving easier, but perhaps you’ll also experience other life changes like having a family or want to pursue other financial goals like buying a home, which will add financial constraints.
If you start investing during the objectively difficult period of graduate school, you’ll always be able to say, “I was able to save during graduate school, so of course I can continue to save now.”
Another big argument in favor of starting to invest during grad school is the tax advantages. In this case, having a low income actually works in your favor! (And not because of the Saver’s Credit.)
Graduate students with taxable compensation are eligible to contribute to an individual retirement arrangement (IRA). An IRA is a wonderful vehicle for anyone with the goal of saving for retirement. The big upside to using an IRA (or 401(k), 403(b), etc.) is that your money won’t be taxed while it’s growing inside the IRA. If your money were invested outside the IRA, the yearly taxes would essentially erode your rate of return and lower your balances.
When you open an IRA, you have the option to make it a traditional IRA or a Roth IRA. With a traditional IRA, you take a tax deduction on the money you contribute and pay ordinary income tax on the IRA distributions in your retirement. With a Roth IRA, you pay your full tax on the money you contribute and the distributions are tax-free.
For the typical young graduate student in the 15% (or lower) marginal tax bracket who expects a much higher income post-graduation, a Roth IRA is a fantastic choice. You pay your 15% income tax on the money you contribute to your Roth IRA, and that money is never subject to income tax again! It’s a great idea to add to a Roth IRA when you’re in a low tax bracket like while in graduate school. If you do have a higher income after graduation and a higher marginal tax bracket, you’ll either pay a higher tax rate to contribute to a Roth IRA or switch to a traditional IRA. When you consider that some people contribute to Roth IRAs when they are in much higher tax brackets, a 15% tax rate seems like a deal!
Even if you do not have taxable compensation, your low tax bracket is still an advantage for long-term investments. If you are in the 15% tax bracket, you have 0% federal tax on long-term capital gains and qualified dividends. This means that investing outside an IRA is not such a terrible fate because of your low tax bracket as long as you use a tax-efficient investing strategy such as index fund investing.
If nothing else, having money increases your options. Exiting graduate school with savings and investments gives you more flexibility when it comes to financially motivated decisions like where to work and how to live. If you already have a nest egg compounding in your corner, you can consider the lower-paying job that fulfills your passion or the high cost-of-living city that you love. You are no longer hamstrung into maximizing your salary and minimizing your lifestyle so that you can compensate for the opportunity cost of your graduate training.
Further reading: What We Did in Graduate School to Enable Our Risky Career Decisions
I hope that considering all the benefits of investing has motivated you to start investing or increase your contributions during grad school! It’s amazing to graduate with not only a degree but also sure financial footing.