Raising Wealthy Children
I grew up in a wealthy suburb of Philadelphia--the kind of place where it wasn’t unusual for classmates to get brand new BMWs on their 16th birthdays. My parents didn’t get me a car when I got my license; they insisted I buy one with the paychecks I earned from my part-time jobs (which took a couple years). We didn’t go on lavish cruises or European trips during school breaks, as many classmates did. And when I’d nag my mom to buy me the latest trendy fashion, she had no problem saying “no.”
I was disappointed at the time. But as an adult, I’ve come to appreciate the commitment my parents made not to spoil me, and to instill me with a strong work ethic and sense of independence. Beyond that, their stubborn frugality allowed them to sock away plenty of money for bigger goals like college tuitions for me and my brother.
As a mother myself now, I’ve adopted some of their tactics with my own kids. As a financial advisor, I’ve also discovered additional strategies that can make an even bigger difference in the long run. Keep reading for 10 ways to set your kids up now to be financially successful as adults.
Teach them early.
The sooner kids learn about the value of money and how to manage it, the better. Every day, my husband and I give our two toddlers our leftover change. We count it together and then they excitedly deposit it in their respective piggie banks. I know they don’t really understand what it means yet; but when they’re a little older, I plan to have them learn how to live within their piggie means.
An allowance is a good teaching tool, but it can also be pointless if you don’t have a plan ahead of time and clear rules. One suggestion is to give your child a certain amount each week (whatever you think is reasonable for their age and your area’s cost of living) and force them to budget accordingly, with no exceptions.
For teenagers, open a separate account funded with a certain amount of spending money for the month (ideally with money that they have earned themselves) and give them a debit card--with no overdraft protection. That way, they don’t have to carry cash on them and they have to learn how to budget.
You can also make household money management a family affair: involve your kids in paying bills, balancing your checkbook, checking your account statements, etc so they become familiar with their future responsibilities. For more ideas on how to teach your kids about money, check out this great site created by the President’s Advisory Council on Financial Capability.
Fund a “kiddie” and your own Roth IRA.
Your teenager can contribute to a Roth IRA up to the amount they earn from eligible employment (cash from babysitting doesn’t count). Money saved in their Roth won't hurt their chances for financial aid since the Free Application for Federal Student Aid (FAFSA) doesn't ask about Roth assets or contributions. (Note that the FAFSA does ask about contributions into traditional IRAs.)
If your teen is living on the money they earn, a good strategy is to offer to match every one of those dollars, on the condition that you contribute that money to a kiddie Roth IRA on their behalf (but only if you have maxed out your own Roth IRA contributions FIRST!). This is a win-win-win for your kid: they essentially get free money for working hard, you can take the opportunity to teach them young about investing, and starting an investment account this early allows them to take full advantage of the power of compound interest, which can pay off big time for them in the long run if they can leave it alone.
Plus, with a Roth IRA, their contributions will grow completely tax free if they wait to withdraw money until after age 59 ½. Another bonus: they can actually withdraw up to $10,000 tax-free for a down payment on their first home. When it comes to your estate planning, keep in mind that your kids will be better off in the long run inheriting a Roth IRA from you or their other parent than a traditional IRA. This is because they would owe income taxes on the annual minimum distributions (RMDs) they would be required to take from a traditional IRA. However, with an inherited Roth, no taxes would be due on RMDs. This means that your kids can keep more of their savings to ideally grow over the long term. If you currently have a traditional IRA, you can consider converting it to a Roth IRA, which may be better for you too in the long run since your money can grow tax free and you wouldn’t have to start taking minimum distributions at 70 ½ if you didn’t want or need to. Just remember that you will owe taxes on any money you convert that you haven’t yet paid taxes on in the year that you convert it.
Invest in a 529.
If saving for college is a priority for your family, you need to consider a 529 college savings plan. The total outstanding student loan debt in the U.S. currently over $1 trillion and the average amount of individual student debt now tops $25,000. The burden on younger generations trying to become financially independent, let alone rich, is bigger than ever before.
A 529 plan can help you give arguably the greatest gift to your children (education) and the next greatest gift of debt relief. It allows you to grow money tax-free if it is withdrawn to pay for higher education and related expenses, and in most cases, it doesn’t affect financial aid eligibility. There are no income restrictions when it comes to funding a 529 and an individual can contribute as much as $13,000 per year without getting hit with the gift tax. Even if your child doesn’t ultimately need or want the money saved in a 529, it can easily be transferred to an alternate beneficiary such as another child, cousin or even yourself.
Each state offers their own 529 option and many plans offer low administrative costs and a state income tax deduction for deposits. However, beware of other plans with high fees (especially if you buy through a broker) and no tax deduction (like the Texas plan). Take the opportunity to teach your kids about investing by involving them in the account opening and management process. The Saving for College site lets you compare 529s and get more information on specific plans.
Sell them on a bargain bachelor’s degree.
Private colleges can often be high cost and low return. Even out-of-state tuition at many public schools can average over $30,000 a year. Unless your child’s received a scholarship to a particular school, is passionate about pursuing a niche major, or manages to get into an Ivy League school (since one could argue that the networking potential at those schools is well worth the cost), encourage them to seriously consider a low-cost option for their undergrad degree. For most general bachelor of arts or science degrees, a public school in their home state is just fine. (Plus, the convenience of staying closer to home, where they can benefit from free food and laundry, is a nice bonus to your kids’ future bottom line.)
Another budget option gaining popularity is doing a year or two at a community college first, where they can get pre-requisite classes out of the way without spending a lot, and then transferring to a state university. The cost savings by going this route can be huge. Lastly, if your kid doesn’t know what area of study she wants to pursue, it might be better for her to defer college for a year or two so that she can work or intern. This way, she can gain some valuable personal and professional experience, earn and ideally save some money, and then pursue a degree with focus, which can lessen the chances of switching majors during college that can delay graduation and increase costs.
Explain that more degrees don’t always mean more income.
You might be proud to brag about your son or daughter going to med or law school, but the cost and time required for those degrees might not actually be worth it in the long run. An advanced degree can warrant a higher salary in many cases; but, by the time your kid earns that money, chances are they will already have a mountain of student loan debt that they have to pay off.
For example, the average physician earns around $185,000 per year, but first has to spend eight years in postsecondary school and another 3-8 years in internship and residency programs. The average public medical school tuition is nearly $30,000 a year and over $50,000 a year for private school (multiply those numbers by 4--gulp!). On the other hand, there are other careers that require much less education and study time and still offer competitive wages that can be saved and invested much sooner. For example, a registered nurse only needs a two-year associate’s degree and can still earn over $100,000 a year in some areas of the country.
That doesn’t mean discouraging your kid from becoming a doctor. But it’s important that they understand the time and money the profession they choose will require and do the math before they commit to another four years--or more.
Give them granny’s IRA.
In the event you inherit an IRA from your parent and your children are secondary beneficiaries, it’s a better tax move to “disclaim” the money so that it gets passed to your kids instead. A bequeathed IRA that skips a generation allows the account to compound tax-deferred for many more years. Why? Because IRA beneficiaries are required to take annual minimum distributions (RMDs) from the inherited account that are based on their life expectancies and pay taxes on the distributions based on their tax rate. Because your kids have longer life expectancies, their RMDs will be significantly less, allowing more of the money in the account to grow over the long term. And because they are younger, they are likely to be in a lower tax bracket.
This strategy provides your kids with a great head start on tax-deferred savings and in the meantime, they can stick their RMDs into a taxable (non-IRA) account for another savings boost and opportunity to learn about investing. Your kids will gain control of both the inherited IRAs and taxable accounts upon reaching majority–usually at 18 or 21, depending on the state. But if you’ve groomed them right, they will smartly leave that money to grow for many more years before using it.
Gift your taxable investment growth.
If you happen to own a variety of investments and are in a higher tax bracket, you may want to consider gifting your appreciated securities in a taxable account to your kids, if they are 24 and older. Assuming they have no or low income (under $36,250, or $72,500 if married filing jointly), they would owe zero federal taxes on long-term capital gains. (If you do this with kids under age 24, they may get hit with a kiddie tax, which would subject investment income over $1,900 to your tax rate--$1,000 if they are 18 and younger.)
Gifting stocks, bonds and funds can be a great way to teach your kids about investing and you can take the opportunity to monitor their investments with them on a regular basis. Just remember that if you give over $13,000 in one year ($26,000 if married), you’ll be subject to the gift tax. Though you could sell your portfolio losers to lower your income tax liability.
Invest in permanent insurance.
To be able to leave behind any significant estate to your kids and grandkids you would probably have to save multi-millions of dollars by retirement. For many of us, this is likely an impossible goal. However, there is a simple solution to create a legacy of wealth even if it escapes your lifetime: permanent life insurance. Permanent insurance allows you to buy a particular amount of coverage (a.k.a. “death benefit”) that is paid--income-tax free--to a designated beneficiary or beneficiaries upon your death. The three main forms of permanent life insurance are whole, universal and variable, all of which offer a cash value component that you can withdraw mostly without restriction as needed (as opposed to term insurance which has no equity).
Universal and variable life insurance policies allow you to adjust your death benefit and premium payment and grow your cash investment beyond a guaranteed rate of return if you’re interested. The catch is that premiums for permanent policies are much higher than term policies. For example, a healthy 40-year-old person who pays $350 a year for a $500,000 term policy might pay around $3,000 a year for a $500,000 universal life policy. This is because of the added cost of lifetime coverage and benefit of cash value growth. While the cost may seem unreasonable at first, if you think about getting a 200+% return on an investment that can ensure a legacy for your future generations, it might be worth it to you. If permanent insurance is cost prohibitive at this point in your life, you may consider getting a convertible term policy in the meantime that is much cheaper and can be converted to permanent insurance in the future when you can more easily afford the higher premiums. The Life and Health Insurance Foundation for Education (LIFE) offers more information on permanent life insurance and how to buy it.
Give them a housing head start.
With interest rates on the rise again and mortgage lenders requiring at least 20 percent down in most cases, buying a home might be out of reach for many younger Americans struggling to manage the burden of growing student loan debt and a tough job market. Census Bureau data revealed that the biggest declines in homeownership were among households headed by those under 35 years of age, with rates dropping from a high of 43.6 percent in 2004 to 36.3 percent at the end of 2012. This is worrisome since real estate is a valuable investment, offering the biggest source of equity that many people have.
Giving your kid the gift of a down payment that allows them to take advantage of the still relatively low mortgage rates and gets them into their first home can create a benefit that compounds for years to come. There’s a powerful tax advantage to owning rather than renting that goes well beyond the mortgage interest deduction: up to $500,000 of homeowner capital gain is exempt -- something you don’t get with capital gains on other investments. If your kid is getting married, consult the in-laws about splitting a down payment as a wedding present and then see if the couple is open to that as a gift in lieu of paying for an expensive wedding. Bonus: helping your kid get their own home will also keep them from being tempted to move back in with you.
Foster a family business.
Most wealthy families build their legacies from successful family businesses passed down generation to generation. Sure, working 30+ years for the same company can offer you a decent pension--or a well-funded 401(k) anyway--but there is nothing in it for your kids and grandkids once you retire. By owning your own business, getting your kids involved and creating a succession plan, you can help ensure your own family legacy.
If you own a business, put your kids on the payroll as an assistant. Of course they have to be qualified enough to do the job and you have to pay them what anyone else in that position would be paid, but the tax benefits as a family could be huge. A child with no investment income pays zero percent tax on the first $6,100 of earned income. So, by shifting income from yourself to your kid, you can eliminate the federal tax hit from as much as 35 percent to nothing and more than cover the Social Security tax imposed on earned income. This income-shifting strategy can be nicely combined with the kiddie Roth strategy mentioned earlier.
Some college students who work in a family business may also be eligible for the American Opportunity Tax Credit ($2,500 per year for four years of post-secondary education) that their high tax-bracket parents cannot claim. In addition to gaining valuable work experience, if they earn enough income, they might be able to escape the kiddie tax on gifts of appreciated securities. Together, these strategies can give your kids a big get-rich boost: lower income taxes, no tax hit on investment gains, a head start on their tax-advantaged savings, reduced college expenses, and valuable work experience in the family business that will hopefully continue under their leadership in the future.