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Financial guide to raising children

(Article by Clare La Plante from Your Money Magazine, December/January 1997)

Our children enrich our lives but drain our finances. There are ways, however, to make the cost of bearing, raising, and educating children more reasonable.

When 17-month-old Henry Klauke of Oak Park, Ill., said his first word several months ago, it wasn't Mama or Papa. It was ball. Henry uses that word to label all things round, from the moon to the baseball that he carries with him everywhere. His sports interest isn't limited to balls: He has a mean swing with his plastic bat too.

His parents, Cathy, a corporate trainer, and Joe, an attorney, wouldn't mind too much if Henry's budding sports enthusiasm helped him to follow the path of a paternal aunt and uncle who attended college on full athletic scholarships. Just in case he doesn't, however, they've already begun a college savings plan in a growth-oriented mutual fund. More importantly, they are determined to teach Henry money management by instruction and example.

Although putting away money for college may seem to be enough financial planning - an easy assumption when public college costs for today's newborns are estimated to be in the $150,000 range - that's just one piece of a large puzzle for a growing family.

There are a myriad of other financial factors involved. Today parents struggle not only with mortgage payments but often with day-care expenses. What's more, a family's other expenses - health care, for example - skyrocket when a new member is added. But having a child doesn't change the need for new parents to plan for their own future and eventual retirement.

However, as the Klaukes discovered soon after the birth of Henry, the old stand-bys still work. If you pay attention to the money you spend, plan for emergencies, invest for retirement, and take full advantage of tax-deferred and tax-exempt savings, not only will you meet most of your financial goals as a parent, you will probably come out ahead.

Spend Plan. The most basic steps can be the hardest. Darryl Reed, president of Money Minds, a national fee-only financial-planning firm - and a new parent himself - says that living within your means is the basis for financial solvency. "Our philosophy is to help people do more with the 95 percent they spend rather than the 5 percent they invest," he says.

But as Reed discovered with the arrival of Jonathan, now a year old, everything changes with the birth of a child. Reed was surprised at the cost of incidentals. "You get the larger items, like strollers, at showers," he says. "But it's the ongoing maintenance, baby wipes, for example, that add up."

Two of Reed's colleagues at Money Minds are also new parents. One, expecting his fourth child, has embraced frugality. "He and his wife make their own baby wipes with paper towels and soap," says Reed. "And they have a food processor to make baby food."

Reed and his wife, Theresa, a military pilot, rely on garage sales. "Toys are expensive," he says. "You can get great things from friends and garage sales." Reed also looks for at least a 10 percent savings - the historic stock-market return - on big items, through store sales or discounts.

Joe and Cathy Klauke also make economizing a priority. Cathy returned to work only recently, and she chose to go back part-time. The perks of a two-income household are gone, and the budget now includes child care two days a week. They haven't given up all extras, but they've put a limit on them. "Now each month we put money in an envelope for dinners out," says Joe. "When it's used up, that's it."

They also revamped their budget. "We were recently looking at our pre-Henry budget," says Joe. "It was a joke." First, they tracked their spending for a month and they found surprising trends. They began cutting back - even on small things. Cathy's early morning stops at Starbucks have stopped - and she's $3.86 richer a day. Larger sacrifices followed. They sold their second car and now take public transportation to work.

Bruce and Kirsten Dillaire, of Worcester, Mass., followed a similar path after the arrival of Alexander, now 4, and Michael, 3. Bruce, a certified public accountant, and Kirsten, an audiologist, live frugally and according to their priorities. "We'd rather have money later than spend it now," says Bruce. "We do very little impulse buying. Our house isn't fancy nor are our cars. We share the same philosophy - we're both savers and we're both thrifty."

Kirsten cut back to part-time work with the birth of Alexander, and left her job completely when Michael was born. "We were putting her entire salary into savings previously," says Bruce, "so we were used to living on one salary."

Saving can mean little, however, if you're unprepared for emergencies. According to Tama McAleese, a Cleveland-based financial planner, contingency planning should be every family's first order of business. This means establishing an emergency fund of three to six months' living expenses in an accessible cash account such as a money-market mutual fund.

Estate Planning. Estate planning isn't just for seniors looking to minimize estate taxes - it's an essential component of a solid family financial plan. New parents need a will, a financial durable power of attorney, a living will, and life, disability, and health insurance.

Will. This legal document dictates how you want your possessions distributed after your death and names an executor to settle your estate. More important for new parents, this is where you determine who will be the legal guardian for your children should both of you die.

Power of Attorney. The financial durable power of attorney, which transfers financial authority in case both parents become disabled, is more important, in my opinion, than a will," says McAleese. Since, according to statistics, a person under the age of 65 is more likely to become disabled than to die, the lack of a financial durable power of attorney could leave a young family financially devastated. "Your family's financial life is dead in the water," she says. "No one can write checks, buy food, or make mortgage payments."

Insurance. Life insurance is a non-negotiable item for new parents. "Young families with two children typically need between $350,000 and $500,000 in death benefits," says McAleese. Even a non-working spouse needs life-insurance coverage: "The value [of a stay-at-home parent] in today's marketplace is very costly," she says.

Although many employers offer life insurance as an employee benefit, the coverage is often inadequate. If that's the case for you, consider purchasing term insurance, which is usually the most cost-effective form of life insurance. To determine how much life insurance you need, see "A Quick and Easy Guide to Life Insurance" in the June/July 1996 issue of Your Money.

And again since you are more likely to become disabled than die at a young age, disability insurance is another necessity. Disability insurance is intended to replace some - at least 60 to 70 percent - of your income in the event you are unable to work. Check with your employer to determine how much (if any) disability coverage you have through your job. If it's not provided or is insufficient, you'll need supplemental coverage.

"Be sure when you're shopping for insurance that you consider the definition of disability," says McAleese, "which means your inability to perform the material and substantial duties of your own occupation." McAleese recommends a renewable, noncancelable disability policy with a guaranteed premium until age 65. Don't buy an "any-occupation" policy just because it's cheaper. To reduce premiums, consider increasing the elimination period, which is the waiting period before benefits kick in. When purchasing life or disability insurance, ask for a specimen contract before you buy. "It's not what they say, but what you sign," says McAleese.

Auto, home, and personal-liability insurance round out this emergency package. Of course, whether you're single, have no children, or are an empty-nester, you need these coverages just as much as new parents do. But new parents on a budget should remember that higher deductibles mean lower premiums. What's more, bundling all your insurance coverage with a single insurer often results in a discount. And if you're running a small business out of your home, such as a baby-sitting service, ask your agent to add an incidental business liability rider to your home insurance.

Health Insurance. Childhood is fraught with emergencies and conditions that require specialists, so an adequate health-care plan is a must. Most people obtain their coverage through the workplace, and today many employers offer several choices. Although HMOs are often more economical, families with young children may consider paying extra for a health policy that allows them to go outside of their network.

Right of Survivorship. It is crucial for parents to include a right of survivorship, or tenancy by the entireties, in their homeowner's deed, says McAleese. Such a clause offers stability in the face of traumatic change. This guarantees, upon the death of one spouse, that the family home is transferred to the surviving spouse without having to go through probate, a lengthy and possibly expensive procedure. "The last thing you want to worry about with the death of a spouse is whether you can keep your home intact," McAleese says.

Long-Term Planning. Once you have your spending under control, an emergency fund stashed away, and contingencies planned for, you can start saving for college - that is, once you have your retirement planning set. "College investing should be on new parents' list," says Reed. "But it shouldn't be an obligation. Take care of yourself first."

Just because college costs are high and rising doesn't mean you must have the full cost in hand the day your child turns 18. McAleese refers to the "three-legged stool" of college financing: Work-study, grants and loans. "Parents are making sacrifices they don't need to," says McAleese. "Ask your child, would you rather have loans [to repay] or have your parents living with you?"

For parents unsure how to proceed, the steps are easy: Put as much as you can into employer-sponsored programs such as 401(k)s. At a minimum, contribute enough to receive the full employer match. If your employer doesn't have a qualified retirement plan, invest through an individual retirement account (IRA). Keep in mind that new legislation allows a full $2,000 IRA contribution for a non-working spouse. The self-employed should set up and fund a Keogh plan.

The further you are from retirement, the more you should invest in equities rather than fixed-income securities such as money-market funds or CDs. Better yet, invest in growth stocks or funds.

The Dillaires, with their safety net in place, are actively saving for both retirement and college. "I believe the stock market is the best place to invest," says Bruce. "And I invest for the long term. We have no CDs, no money in bank money-market accounts, just emergency funds. I invest quite aggressively," says Dillaire. "It will be 15 to 20 years before we need the money."

Their retirement money is stashed in mutual funds through 401(k)s and IRAs. The Dillaires also invest in blue-chip common stocks through divident-reinvestment programs. They have even placed their assets into separate accounts to save on estate taxes.

For college saving, both of their children are enrolled in growth-oriented mutual funds under the Uniform Gift to Minors Act (UGMA). Under UGMA, there's no income tax on the first $650 of unearned income until the child reaches age 14; the next $650 is taxed at the child's rate, usually lower than the parents' rate; and the rest is taxed at the parents' rate. At age 14 and older, all income is taxed at the child's rate.

What's the catch? "You can't change your mind," says McAleese. "Once the child is gifted the money, it's his or hers." And if the income is used for the child's normal living expenses, that income is taxable to the parents.

As with their retirement assets, the Dillaires have put their children's college funds on autopilot. Each child receives a fixed amount each month, automatically deducted from their parents' checking account. "I want them to be able to go to any school they want to," says Bruce.

How well can this work? Even a $50 per month investment will result in $30,278 in 18 years, assuming a 10 percent annual return. As the child nears college, parents can gradually move the money to fixed-income assets, such as money-market funds or CDs.

Another way to save for college is zero-coupon bonds. These U.S. Treasury products do not pay current income. Instead, they are sold at an extreme discount, such as $550 for a $1,000 bond, and can target a specific year for maturation. The drawback? Even though you don't receive regular dividend income from zeros, you pay taxes on the imputed income each year. "Although you pay taxes on the phantom income, it's peace of mind," says Reed.

EE savings bonds are another viable option for college saving. "These are a fairly decent deal," says Reed, "depending on the tax bracket." EE bonds are free of state and local taxes and can be federally tax-exempt if you use them for college funding and meet the income requirements. Bonds must have been purchased after 1989 and the tax-exempt status is phased out when parents' income reaches ceilings that are adjusted annually. For 1996, the income ceiling is $74,200. The Treasury's new inflation-indexed bonds, scheduled to become available in 1998, will also offer tax-exempt income when the proceeds are used to pay for college.

Reed suggests putting savings bonds on your show or christening gift register lists. "I used to regularly buy EE bonds with a small toy for babies," he says. "Grandparents should be great for this."

Financial Education. Perhaps the greatest gift you can give your child is a solid education in financial management. One way is to encourage long-term savings - even for retirement. "Teen IRAs are wonderful," says McAleese. In addition to the financial discipline they offer, "these kids can become millionaires," she says. Creative parents can motivate their children's saving by offering matching contributions - just like employer 401(k)s. Kids can contribute up to $2,000 annually but only up to the amount of earned income they received.

Familiarizing your children with the stock market is another good idea. "I'm trying to involve my kids now," says Bruce Dillaire. "I tell them they are shareholders. When they come into my home office and I'm looking at the stock page, I'll say, 'Hey, guys. We made money yesterday.'"

Kirsten Dillaire says this involvement is now a part of their everyday lives. "As soon as they get money, Alexander and Michael love to put it in their Winnie-the-Pooh banks. I tell them, 'By saving this, we can go on vacation - perhaps to Disney World.' We feel it's a short-term goal that they can understand, so they're a part of it too - even at age 3!"

Young Jonathan Reed is also learning financial responsibility. "He helps me put coins in his piggy bank," says his father. "I'm keeping my eyes open for opportunities to teach him about saving and investing. This, more than anything else, will serve him well throughout his life."

One of McAleese's hard and fast rules of family saving and investing is simple: Part of every dollar your child earns or is gifted should be earmarked for saving.

"A healthy family brings children in on financial decisions. They need a foundation, otherwise they start to believe that Visa and MasterCard are their friends. The best savers in the world are three-year-olds - before exposure to media and instant gratification. Spending and saving are not conflicting goals," she says. "Money is a vehicle."

Cathy Klauke says there is a certain liberation in simplifying your financial life. Her husband agrees. "Ironically enough, cutting back gives us freedom," says Cathy. "It gives us peace of mind."

"Henry gave us a goal," says Joe. "He helped to motivate us."

Financial Checklist for New Parents

Here are steps any family must take when a new child enters the picture, according to certified financial planner Deena Katz, president of Evensky, Brown, Katz & Levitt, a fee-only investment advisory firm based in Coral Gables, Fla.:

  • Review your risk management. Make sure you have adequate life, disability and health insurance.
  • Coordinate your emergency funds with your disability coverage. "If you have a 90-day elimination period before your disability coverage kicks in," she says, "keep an amount equal to three months' basic expenses in an money-market fund." She also suggests keeping a separate emergency credit card, or opening a home-equity line of credit for use as an emergency reserve fund.
  • Make the best use of your employee benefits. Contribute as much as you can into your employer's 401(k) retirement plan or an IRA. "If you are an older parent," Katz says, "this may be an excellent strategy to fund your child's college since you may be at or close to 59 1/2 when your child heads for college. Even if you are not an older parent, the tax deferral may more than make up for the 10 percent early-distribution penalty." Katz also recommends using a flexible-benefits plan, if your employer offers one. You may be able to pay for dependent-car services, glasses, or dental visits not available through your health-care plan.
  • Invest with the long term in mind. College funds, as well as retirement funds, belong in equities. Katz prefers index funds to take advantage of long-term returns on stocks without having to worry about fund-management choices.
  • Estate plan. Even if you have few or no assets, you need a will. "You certainly want to direct who will care for your child if you cannot," Katz says.

Tips for New Grandparents

Curtis Ford, president of American Society of CLU and ChFC, has these pointers for new grandparents:

First of all, Ford says, grandparents need to make sure their financial house is in order before they gift their grandchildren. "They need to understand and make projections of their financial needs, factoring in inflation and taxes," Ford says.

Also, he cautions, never act without conferring with your grandchildren's parents. "First talk with them," he says. "Your plan may conflict with their ideas."

Here are some ways to gift your grandchildren without paying a hefty price.

  • Gift of cash or stock. Federal law lets individuals give up to $10,000 each year to another person; couples can give twice that much. This means that grandparents can give up to $20,000 a year to each grandchild. This can be advantageous if you have a sizable estate, because it gets property out of your taxable estate.
  • Pay education or health bills directly. You can avoid the gift tax on transfers that exceed $10,000 by paying some bills directly, including paying for your grandchild's tuition or medical expenses.
  • Gift of a trust. "Trusts can be designed any way you want," says Ford. "They are very flexible." You can include contingent beneficiaries or terms of distribution.

"These things should be a part of your overall estate plan," says Ford. "You should have your plan in order, normally with the help of an estate-planning team, including an attorney, CPA, bank trust officer, and insurance consultant."