Parents of young children usually have more places that their money needs to go than they have funds to cover every current and future obligation. You can help them sort out where to put each and every dollar each month so that short-term concerns are addressed, yet long-term goals are still achieved. Here’s how parents should distribute their income on a month-to-month basis and how to save for retirement (and college) along the way.
Step 1: Cover the Basics
First, have them identify where their money is currently going every month and in what amount. They will then know if any money will be left over and what could be cut to generate more discretionary funds. Wherever possible, they should establish automatic payments debited from their checking accounts towards utility, credit card and other loan payments. This will help them avoid missing a payment, which could then damage their credit score and cost them untold amounts in higher interest expenses, as well as preclude future borrowing opportunities.
Retirement savings: If either of the parents have an employer matching feature to their at-work retirement plan, have them save enough to receive this ostensibly “free” money from their boss.
Step 2: Build up the Savings
The next step is to make sure they have enough liquid funds in a separate account to cover short-term surprises (such as car repairs) and bigger financial emergencies like a job loss.
At a minimum, this account should equal three months’ worth of basic living expenses, a figure the parents have hopefully established in the first step. Because the funds have to be readily accessible and safe, the most sensible investments for the “rainy day fund” are a checking or money market account, or perhaps a longer-term certificate of deposit with a minimal penalty for early withdrawal.
Qualifying parents can deposit those savings into a Roth IRA then withdraw the contributions at any time for any reason, with no taxes or penalties.
Step 3: Dealing with Debt
After making sure that monthly bills and minor crises are covered, it’s natural that responsible parents would like to pay off as much debt as they possibly can.
Yet, there are some loans that should be paid off as soon as possible, and others that should only be attended to after all other needs are met. Credit card balances should attract all of the initial extra dollars, especially if the interest rates are in the double digits. Zeroing these accounts out will not only improve the parents’ credit scores and save them a ton of money in interest, but then the available credit can be used when a financial crisis exceeds their liquid savings.
After the plastic is paid off, they should start paying off student loans. But they should only pay extra on education debt with high interest rates and/or ones from private lenders. Federal loans should come next, since those generally have lower interest rates and more forgiving repayment terms. For more information, send the clients to www.ibrinfor.org.
Vehicle loans shouldn’t be prioritized for repayment, especially if the interest rates on this type of debt is little or nothing. Mortgages, home equity loans and home equity lines of credit should generally not be retired early until the parents are just about retired, especially if the debt has a fixed-rate loan costing 4 percent or less in annual interest.
Retirement savings: As a rule of thumb, it’s usually better for borrowers to pay off debt instead of saving more into a pre-tax retirement plan, especially if the interest rate on the debt is greater than 10 percent and/or the borrowers are in the 15 percent federal income tax bracket or below.
Step 4: Save More for Retirement
At this point, many parents will want to know why they should save more for retirement (a goal that could be decades away) instead of setting aside money for their kids’ college expenses which may be looming much sooner.
There are several reasons: First, it’s possible to borrow money to pay for college (assuming the kids go), but the clients will not be able to fund their retirement with debt. Second, the parents can use their Roth IRA contributions to pay for college costs, with no taxes or penalties. Finally, most schools won’t include the balances of retirement accounts in their formulas that determine need-based financial aid awards. But, they will include contributions made to the retirement accounts in the year in question.
How much should parents save for retirement each year? Probably at least enough into pre-tax retirement vehicles to get their taxable income below the top of the 15 percent federal income tax bracket for the year. The figure that determines the federal income tax bracket is on Line 43 of the clients’ 1040. For 2017, the top of the 15 percent bracket is $37,950 for single filers and $75,900 for married couples filing jointly.
Step 5: Anticipated Expenses
A separate account should be set up to cover expenditures that are necessary, important, likely to occur in the future and for which the parents would rather not charge to a high-interest credit card account. These might include braces for the kids, a family vacation or trip, or home improvements and new furnishings.
Retirement savings: If a particular urgent expense exceeds the family’s available savings, they may be able to cover the difference relatively painlessly via withdrawals of Roth IRA contributions, or when available, borrowing from an at-work 401(k).
Step 6: Save for college
Last, but certainly not least, is the need to set aside money for future higher education expenses. Ideally after addressing the issues covered in the first four steps, the parents will still have some extra funds available. But those who don’t have enough to save for four years of college (let alone an advanced degree and/or the education costs of multiple children) shouldn’t despair. Next time we’ll tell you how families who aren’t independently wealthy have managed to pay for their children’s college education, without going bankrupt in the process.