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. 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 appreciate my parents’ commitment not to spoil me.
As a mother now, I’ve adopted some of their tactics. And as a financial advisor, I’ve also discovered additional strategies that can make an even bigger difference. Here’s how to set up your kids to be financially successful adults.
[Editor’s Note: This is an updated version of the original, which was published in August 2013.]
The sooner kids learn the value of money and how to manage it, the better. An allowance is a good teaching tool, but it can also be pointless if you don’t have a plan and clear rules.
Try one of these tactics:
- Give your children a certain amount each week (whatever you think is reasonable for their age and your area’s cost of living) and have them budget accordingly, with no exceptions.
- Open separate accounts for teens funded with a certain amount of spending money for the month (ideally with money they earned themselves) and give them a debit card — with no overdraft protection.
And don’t forget to involve your kids in paying bills, balancing your budget, and checking your account statements, so they become familiar with their future responsibilities.
Open a Roth IRA for Your Teen
Your teen can contribute to a Roth IRA up to the amount they earn from eligible employment (cash from baby-sitting doesn’t count). Money saved in their Roth won’t hurt their chances for financial aid, since FAFSA doesn’t ask about Roth assets or contributions. Note: FAFSA does ask about contributions to 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 Roth IRA on their behalf (but only if you’ve maxed out your own Roth IRA contributions first!). This plan is a win-win: Your kid essentially gets free money and you teach them about investing. Plus, starting an investment account early allows your teen to take full advantage of compound interest.
Plus, with a Roth IRA, their contributions will grow completely tax free if they wait to withdraw money until after age 59½. Another bonus: They can actually withdraw up to $10,000 tax free for a down payment on their first home. Your kids will be better off in the long run inheriting a Roth IRA than a traditional IRA — this way, they can avoid income taxes on the annual minimum distributions (RMDs) required from a traditional IRA.
Invest in a 529
The burden on younger generations trying to become financially independent is bigger than ever before: The total outstanding student loan debt in the U.S. is $1.3 trillion and this year’s graduates’ average debt hit a record-breaking $37,172. If saving for college is a priority for your family, you need to consider a 529 college savings plan.
With a 529 plan, you can grow your money tax free — if it’s withdrawn to pay for higher education and related expenses — and in most cases, 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 $14,000 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.
Each state offers its own 529 option and many 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). The Saving for College site lets you compare 529s and get more information on specific plans, and you can take the opportunity to involve your kids in the process of opening and managing the account.
Sell Them On a Bargain Bachelor’s Degree
Unless your child received a scholarship to a particular school, is passionate about pursuing a niche major, or manages to get into a very elite 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 undergrad. 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.
Another budget option gaining popularity is doing a year or two at a community college first and then transferring to a state university. The cost savings by going this route can be huge. And if your kid doesn’t know what area of study they want to pursue, it might be better for them to defer college for a year or two and work or intern in their field of interest. This way, they gain some valuable personal and professional experience, earn and ideally save some money, and then pursue a degree with focus.
Explain That More Degrees Don’t Always Equal More Money
You might be proud to brag about your daughter or son going to med or law school, but the cost and time required for those degrees might not 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, they will already have a mountain of student loan debt.
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 needs only a two-year associate’s degree and can still earn more than $100,000 a year in some areas of the country.
This doesn’t mean you should discourage your kid from becoming a doctor. But it’s important for them to understand the time and money the profession they choose will require and to do the math before committing to more years — and more debt.
Transfer Your Inheritance
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, because IRA beneficiaries are required to take annual minimum distributions (RMDs) from the inherited account.
These RMDs are based on life expectancies, and are taxed based on your tax bracket. 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 since they’re younger, they will likely 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 an opportunity to learn about investing. Your kids will gain control of both the inherited IRAs and taxable accounts at 18 or 21, depending on the state.
Pass on Your Investment Growth
If you 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 or older. Assuming they have no or low income (under $53,900, or $83,800 if married and filing jointly), they would owe zero federal taxes on long-term capital gains. Note: If you do this with kids under age 24, they may get hit with a kiddie tax, which would subject investment income over $2,100 to your tax rate.
Gifting stocks, bonds, and funds can be a great way to teach your kids about investing, and you can monitor their investments with them on a regular basis. Just remember that if you give more than $14,000 in one year, you’ll be subject to the gift tax. However, you could sell your portfolio losers to lower your income tax liability.
Give 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. Giving your kid the gift of a down payment 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.