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Helping Your Child Build a Strong Financial Future
By Nancy B. Crowley, CPA
If you have an adult child, you probably are concerned about their financial well-being.You most likely have asked yourself questions such as: how can I help my child to become more financially independent? What can I do to help set my child up for financial success?Does my child have the tools to handle any financial matters they may face?
In 2017, the National Endowment for Financial Education issued a report based on a study focused on 23 to 25-year-old young adults and their financial behaviors. The study found that while the millennial generation is diverse and highly educated, they are lacking in financial knowledge. Only 24 percent of the study respondents showed basic financial literacy and just 8 percent showed a high level of knowledge.Interestingly, 69 percent assessed themselves with having high financial knowledge.
Over the years, we have helped our clients answer the age-old question: how can I help my child get started financially?We have found that a successful financial future is built on a foundation comprised of the following key action steps:
Keep Credit Card Debt in Check
Young adults are inundated with credit card offers. On one hand, having a credit card and using it responsibly establishes a favorable credit history. However, not keeping up with the payments is a quick way to establish a poor credit history. It is very tempting for your child to sign up for a store credit card when a cashier is offering a discount on their purchase, but store credit cards typically carry higher interest rates than general purpose credit cards. The best advice is to obtain one credit card and use it responsibly. A credit card balance should be paid in full each month.
It is important for your child to keep their credit utilization ratio below 30%. The credit utilization ratio is calculated by taking the amount of revolving credit currently outstanding divided by the total amount of revolving credit available. This ratio significantly impacts an individual’s overall credit score when applying for a mortgage, car loan or any other borrowing.
Your child may be an authorized user on your credit card which can positively or negatively impact their credit standing. If you as the parent are current on your payments and do not routinely max out the card, a child piggybacking on to your credit card should provide them with a good credit score. If you, as the primary account holder, regularly max out your credit card limit or miss a payment, you will negatively impact the child’s credit score. Keep in mind that once an authorized user (your child) is removed from the account, the credit impact of that account is usually removed from the authorized user’s credit report.
Establish a Retirement Nest Egg
Your child may see retirement as a long way off, so naturally they will question why they should be concerned about it now. Setting aside money for retirement now, which grows with income and appreciation, means that a considerable amount will be available when they are ready to retire. If an employer provides a 401(k) plan, it makes sense to contribute at least as much as the maximum amount of the employer’s contribution as that is free money. The 401(k) contribution is automatically withheld pre-tax from a paycheck, so in essence it is never available and therefore never missed.
In addition to workplace retirement plans, there are other retirement savings plan options including IRAs and Roth IRAs. There are many rules concerning IRAs. A basic IRA contribution results in a tax deduction. The funds contributed are invested and grow tax-deferred until withdrawals occur at retirement. The withdrawals are then taxed as ordinary income. A Roth IRA differs from an IRA in that it is funded and invested with after-tax dollars. The investment grows and all withdrawals are tax free at retirement. A Roth IRA is an ideal retirement vehicle for young people as they have a long-time horizon before retiring so there is potential for significant tax- free investment growth. In addition, your child generally will have a lower tax rate now than in retirement, and as such, will have a better overall tax result using a Roth IRA.
Create a Budget
To help achieve financial success, your child will need to learn how to manage their own money. The goal is to live within their means and prevent overspending. Creating a budget is fundamental in getting a handle on anticipated income and expenses over time, as well as differentiating between actual needs over nice-to-have wants.
To get started in creating a budget, your adult child should:
- Calculate their monthly spending. They can do this manually by reviewing checking accounts and credit cards, but a better option would be to use one of the many online options like Mint, Personal Capital, and PocketSmith. There are also envelope budgeting mobile phone apps like Goodbudget, Mvelopes, and SimpleBudget that can help your child compartmentalize and track his or her spending on a mobile phone. Your child’s bank may also have additional budgeting tools available.
- Calculate monthly income.
- Subtract monthly expenses from monthly income. Hopefully the net of the monthly income and expenses is a positive cash balance. If not, then evaluate whether one or two discretionary expenses can be reduced or eliminated.
- Establish savings and debt payoff goals, assuming there is remaining available cash.
Budgets may be created manually, on an Excel spreadsheet, or through mobile phone apps mentioned above, and other internet services. One example of a simple budget plan is the 50/30/20 budget. In this plan, approximately 50% of your child’s after-tax dollars is spent on necessities including housing, utilities, groceries, transportation, and insurance. The next 30% or less may then be spent on wants such as dinners out, travel, entertainment, and gifts. The final 20% or more should be allocated to savings and debt repayment.
A top priority in the 20% category would be an emergency fund. The goal is to save enough to cover three to six months of necessary expenses. The emergency fund should be liquid and easily accessible. Another priority would be to sign up for the employer’s workplace retirement plan (401(k), 403(b), or 457 plans) by contributing at least enough to obtain the employer’s maximum match. An additional priority would be to pay off any debt.
Build an Investment Portfolio
Unlike an emergency fund which should be liquid, investing in stocks and bonds is a way of increasing wealth. When people are young, they may be willing to take on more risk as they are investing for the long term.Historically, the Russell 1000 Index has shown that the stock market has delivered an approximate 10% average annual return so a young adult can ride out the market’s ups and downs. Bonds may be added to the investment mix as they are considered a safe, lower return investment that can counter the risk of stocks.
Guard Against Risks Through Insurance
If your child is under the age of 26, chances are they are still covered under your family’s health plan.What happens when your child is no longer covered by your health plan?Understandably, your child may view health insurance as an expense without any immediate benefits. To secure their own health coverage, your child should start with their workplace. The trend seems to be that employers are offering high deductible health insurance plans which then are supplemented with a Health Savings Account (HSA).The HSA is funded when your child contributes pre-tax funds into his or her HSA.Once the funds are contributed to the plan, they may be used tax-free for qualified medical expenses.The potential for growth in the HSA is dependent on annual contributions to the plan and medical expenses paid out.One benefit of an HSA plan is that the plan balance in excess of $2,000 may then be invested.For 2019, the HSA contribution limits are $3,500 for a single individual and $7,000 for a family. HSAs may work very well for young healthy adults.
Other insurance, including life insurance, homeowner’s or renter’s insurance, car insurance, disability insurance, umbrella liability policies and even pet insurance, must be evaluated based on the individual’s specific needs.
Say “I Do” to a Prenuptial Agreement
You probably have made provisions for your child in your estate plan.If your child is planning to get married soon, you are likely wondering how you can protect the assets you have already given to your child, as well as their future inheritance. The answer lies in a prenuptial agreement.A prenuptial agreement is a written contract created by two people before they are married. There are many reasons for having a prenuptial agreement, but the overall emphasis is on protection of separate property, alimony, and division of property. The agreement lists all the property and debts that each person is bringing to the marriage. From there, the agreement specifies how those assets and future assets will be divided as well as covers other financial issues of a divorce. Hypothetically, it’s best to let it be known in advance the need for a prenuptial agreement so that one individual doesn’t feel forced or rushed into something he or she doesn’t agree with or understand.
Document Decisions & Wishes Through Estate Planning
It is not unusual for your adult child to not want to focus on estate planning, but once your child turns 18, you lose the legal ability to make decisions and to find out even the most basic information about your child. Therefore, it is important that your child has an estate plan which includes at a minimum the documents listed below:
- A Health Care Proxy which is a legal document specifying who has the authority to make health care decisions on behalf of your child in the event of incapacity.
- A Durable Power of Attorney which is a legal document designating a person who will act on your child’s financial behalf when he or she is unable to do so.
- A Will which is a legal document stating who will inherit their assets and handle their affairs upon their death. This document can also be used to name guardians for their children should they have any.
At RINET, we are experienced in managing complex inter-generational issues and would be happy to have these discussions with you or your child. We are here to help you help your child build the foundation for a strong financial future.