An emergency fund is used to pay your living expenses during unemployment. It should hold 3-9 months of current earnings. Keep it for retirement.
Unemployment means that you aren’t paid for doing work.People who either lose their job or retire from work are unemployed. Could you pay for living expenses during unemployment?If not, you should start building an Emergency Fund. There are two important savings plans during life: the Emergency Fund and Retirement Account (ref. 1).
The emergency fund is used to pay living expenses during temporary unemployment and other unusual expenses such as big bills.Workers should save 3-9 months worth of earned income in a secure savings account (ref. 2).That’s a difficult task when also planning to buy expensive items such as cars and houses, or paying-off college loans.Get a headstart in childhood by slowly saving cash in a custodial bank account.
The retirement account is needed to pay living expenses during permanent unemployment in old age.Contribute to your own retirement accounts as soon and often as possible (ref. 3).Begin by opening a Roth IRA during childhood when you start reporting earned income to the Internal Revenue Service (ref. 4).Employer-sponsored and Self-employed retirement plans should be opened at the first opportunity (ref. 5).
About forty to fifty years of regular investing are needed to build adequate savings for retirement (ref. 3). Plan on investing in quality securities such as stock index funds and government bonds (ref 1,6).Begin with stock index funds early in life and add the bonds late in life, finishing with a 90% investment in stock funds and 10% investment in bonds (ref. 7).
Retirement accounts have special rules for investing money (contributions) and removing money (withdrawals).
Withdrawals before age 59½ years are generally not permitted without paying a fine and taxes [check the rules for exceptions in ref. 5].There are no fines after age 59½ years.
Roth IRA. You must pay taxes on all contributions and the contribution limits are $5,500 per year [check ref. 5 for changes].Withdrawals after age 59½ are not taxed and there are no mandatory withdrawals.
Other IRAs and retirement plans. The contribution limits vary from $5,500 to $19,000 depending on the account [check ref. 5 for changes].You don’t pay taxes on any contribution, but withdrawals are always taxed.The government requires partial withdrawals each year after age 70½ years.
Children have the gift of time for building their future.Unfortunately, thousands of young people waste their early opportunity to start building an emergency fund, saving for adulthood, and investing for retirement.Here are 3 examples:
A neighbor who finished the first year of college with a 3-point average (good grades!) decided to move to New York to find a job and live with her sister. This was not surprising when considering that she used to sell stuff door-to-door to earn money. What surprised me was that she asked if we had any advice? “Yes”, I said, “invest in a Roth IRA”. “What’s a Roth IRA?”, she asked. Neither she nor her college-graduate parents knew about IRAs.
Two grandmothers told me on separate occasions that they wished their young adult grandsons would invest in the stock market.
References 1 & 2 describe the problem and correction for delinqent investing.
Children have the advantage of a long TIME-period for investing toward college and retirement. Family teamwork is essential to that process and grandparents can be an integral part of the team.
This presentation will explore ways that seniors can facilitate their grandchildren’s long-term investments. In viewing my presentation, please understand that I am not a professional financial advisor; I merely advocate frugal, do-it-yourself investing for all ages. I would like to emphasize the following thoughts:
Young investors have the advantage of TIME.Will they use it wisely?
Becoming informed investors starts at home with the family traditions of money management.
Save for retirement?Form the savings habit early in life.
College is any certified program of higher education. Paying for college requires ‘college prep’.
Grandparents have the resources to help young investors and college students.
The Advantage of TIME
The advantage of TIME is to help build wealth by reinvesting dividends and capital gains. Those reinvestments promote the growth of a long-term investment project. The black growth curve in chart 1 predicts the future value of $1 invested in the stock market. The colored dots represent the increasing value of the invested dollar with the passage of time.This method of growth is called compounding interest or compounding returns.Notice that,
the growth of $1 to $3.40 in 18 years is a predictable outcome of saving for college.
the growth of $1 to $30-$114 in 50-70 years is a reasonable outcome of investing for retirement.
Wise money-management is an essential skill for investing successfully and protecting those investments.Money management may be a family tradition or a new family experience.Either way, children usually start forming money habits early, before entering elementary school.Many families teach the wise management of money by encouraging their children to store money in jars.
the spending jar facilitates decision-making.Children love money and typically don’t have enough to pay for everything.They should learn to spend wisely and accept the consequences of their choices.If they borrow money, they should learn to pay it back on time.
the saving jar helps make future payments. Saving leads to investing.Help them save for short term goals and encourage them to gradually save larger amounts over longer time periods.Introduce them to the stock market. Consider helping them to buy shares of stock issued by their favorite company.
the sharing jar builds community awareness.Expose children to the needs of others in their community.Sharing money and volunteering to work will cultivate relationships and humane values.
Young children dream about becoming grown-ups.They wonder what adults do for a living and how parents earn incomes. Older children are inspired by classmates, adult role models, field trips, group activities, etc.Family support can help transform these imaginations and inspirations into simple financial goals.Examples of dreams (chart 3):
teenagers want expensive things like cars and computers.
young adults think about weddings and buying a home.
The habit of saving for retirement can be inspired by dreams of becoming millionaires.[My granddaughter read a story in her favorite magazine about saving to become a millionaire.She was fascinated.I discussed the article with her and shared her excitement.I asked her mother (my daughter) if I could provide some seed money to open an investment account at a reputable brokerage firm.A year or so later, my granddaughter started earning money as a tutor and used her earnings to open a Roth IRA.She enjoys reading her financial statements and watching her investments grow in value.]
Financial markets have cycles of market prices that expose investors to the risks of profits and losses.How willing are you to risk the loss of money from an investment compared to its potential profit? Compared to bonds, stocks are high risk, high return investments. It’s very reasonable to expect a good profit from the stock market after 30 years!Children have the advantage of waiting 30 years for a profit after investing in the stock market. Therefore, they can tolerate more risk compared to someone entering retirement.
Finance is the art of putting money to good use. Simple financial plans have an approximate time interval (short-term or long-term), the desired item (chart 3), and a funding method.
Short-term plans are usually low-risk, low-return projects
low-risk refers to dependable investment returns and guaranteed repayment of invested money
low-return refers to low rates of return (e.g., 4% interest rate from high-grade bonds)
Long-term strategies are suitable for high-risk, high-return investments
high-risk suggests a good chance of either earning or losing money from an investment
high-return suggests a higher rate of return than earned from high-grade bonds
Chart 5 summarizes several well-regulated investments for FUNDING desired items. I would like to emphasize that saving and investing are the best ways of avoiding the hazards of debt.
‘Good’ debt is cheaper than ‘bad’ debt.Lenders of good debt require an acceptable credit rating before lending money at a competitive interest rate and reasonable maturity date.Student loans are usually reputable when brokered by college financial aid officers to pay for college costs.Beware: Students can incur high debt by borrowing for extra years of college or attending elite schools. High debt can cause emotional and financial distress.
Informed investing involves selecting the right type of investment, using a frugal method of payment, and forming a plan to protect the investment. Short-term investments (chart 5) have time periods of 1-5 years. The following investments are guaranteed to pay small amounts of interest in addition to returning the investor’s money at a time called the maturity date:
money market funds
certificates of deposit
government bonds that mature within 1 year
Long-term investments (chart 5) have time periods that extend beyond 5 years.
Stocks are certificates of ownership in a company that guarantee the shareholders a claim on the company’s profits.Stockholders earn returns from dividends and capital gains.The expected long-term return is an average annual rate of 7%. There are no guaranteed returns.
Bonds are contracts that guarantee scheduled payments of interest and repayment of the invested money.The expected long-term return is an interest rate of 4%.
REITs are real estate investment trusts that must distribute at least 90% of the trust’s annual profit to its shareholders. There are no guaranteed returns.
Investment funds are pooled investments, typically stocks or bonds, owned by a group of investors.Funds pay interest, dividends, or capital gains to shareholders in proportion to their share of the investment fund.Shareholders also earn capital gains by selling their shares of the investment fund. There are no guaranteed returns.
Mutual funds and ETFs are investment funds governed by the Securities and Exchange Commission (SEC) for the benefit of investors.
529 Plans and Roth accounts are portfolios of government-regulated, tax-advantaged investments.529 Plans are only used as an educational savings plan.Roth accounts are used as a retirement savings plan, but may also be used for the qualified expenses of an education or purchase of a first home.
Frugal investing enhances investment profits by minimizing the impact of fees and taxes. Chart 6 summarizes the traditional ways of investing frugally in stocks and investment funds.
Trading fees: An investor must pay trading fees for every purchase and sale of stocks or investment funds unless otherwise enrolled in a direct purchase plan or no-fee plan.
Automatic reinvestments: Many stock brokers will automatically reinvest their client’s investment returns for free if the shares are already owned.
Dollar-cost-averaging is the practice of investing a fixed amount of money in a stock or investment fund at regular time intervals, typically every month. The advantages are those of having an affordable investment plan and the freedom from worrying about fluctuations in market prices. The potential disadvantage is that trading fees can dilute the investment profits. Some companies and brokers support dollar-cost-averaging by excluding trading fees.
Taxes: Investors must pay federal income tax on investment returns. The Kiddie tax is a provision that excludes children from paying taxes on the first $1,050 of gross income, including investment returns. Nor do children don’t pay taxes on investment returns they acquire in a tax-advantaged education savings account (e.g., “529”) or a Roth IRA.
In childhood, the first serious step toward planning for retirement begins with forming the habit of investing in stocks (chart 7). The prospect of getting ‘rich’ is a strong (but temporary) motivation.Grandparents could help with the investment program.The child investor might have to pay a “Kiddie tax” on investment returns until they can open a custodial Roth IRA.As soon as they start earning income from outside the family, and report that income to the Internal Revenue Service (IRS), they are eligible to open a Roth IRA that can then be used for a lifetime.It’s also important to teach children about the tax-advantaged retirement account known as the employer-sponsored 401(K) plan.
TIMELINE FOR RETIREMENT SAVINGS
introduction to stocks during pre-teen years
teens who earn income from any legitimate employer outside their family can open a Roth IRA
qualified withdrawals will not be penalized or taxed
qualified withdrawals are restricted to paying education expenses, making a partial payment to buy a first house, people with disabilities, and people over the age of 70 ½ years.
employed young adults can participate in employer-sponsored (e.g., 401(K)) or self-employed (SEP) retirement accounts. The contributions are deducted from salaries and may be supplemented by the employer.It’s important to enroll as soon as possible and participate to the fullest extent.
dollar-cost-averaging is the habit of making regular monthly contributions to an investment plan to help protect against fluctuations of the stock market.
Colleges are institutions of higher learning (beyond high school) that are certified trade schools, 2-year community colleges, 4-year schools, graduate schools, or professional schools. College prep is a family enterprise aimed at preparing students for higher education.The family’s financial goal is to balance the cost of higher education with an equal amount of savings and scholarships (chart 8).
Financial aid is used if needed.Grants and work-study programs are types of financial aid that don’t incur debt. Student loans are financial aid that incur ‘tenacious’ debt.
Unlike consumer loans, student loans can’t be cancelled by declaring bankruptcy. The 3 ways of cancelling a student loan are 1) payment-in-full,2) debt-forgiveness for performing public service, or3) death of the borrower.
TIMELINE FOR ‘COLLEGE PREP’:
start early; age 1 or as soon as possible.
the Coverdell and 529 Plan are tax-advantaged educational saving accounts that work best when owned by an adult for the benefit of the student.
grandparents can contribute to their family’s educational savings accounts and help motivate their grandchildren to seek higher education.
the required savings can be estimated with the help of net-price and affordability calculators available for free online.
Scholarships are debt-free awards of money to students based on eligibility and possible conditions of student performance required by the sponsor.Tips for seeking a scholarship:
applications for relevant scholarships are the responsibility of the high school student
require considerable research and effort by the student applicant
start research in first or second year of high school
academic achievement is important, but not the only factor considered by many sponsors
try to accumulate large awards by seeking several relevant scholarships
grandparents might help with the research, proof-readings, practice interviews, travel costs, etc.
Cost of attendance is provided in college web sites.Several ways of reducing the cost are:
high school student may be able to enroll in “early college”
college credit may be earned by successful performance in advanced placement courses and CLEP exams.
more expensive 4-year colleges may accept transcripts from less expensive 2-year colleges.
apply for admission to a “financial safety” college that offers a quality education
Financial Aid is offered by the college’s financial aid officer after the family completes the necessary application forms for enrollment.
submit the forms before, not after, the deadline; early submissions are ‘first in line’ for review by the college and many colleges have a limited amount of un-loaned aid.
expect to complete and submit a Free Application for Federal Student Aid (FAFSA) and College Scholarship Service (CSS) Profile.Both forms are detailed, lengthy, and inquisitive.
Government student loans are generally preferred to private loans.Federal subsidized loans for deserving students with financial need have additional financial benefits.
Government grants are special scholarships offered to deserving students with financial need.
recommendation:apply for financial aid even it is unnecessary.The family could still incur a financial disaster during the next school year.
EFC: The student’s annual financial aid (AID) is computed by subtracting the expected family contribution (EFC) from the annual cost of attendance (COA). The EFC is determined by authorities who review the FAFSAs and CSS Profiles on behalf of college admissions officers. Aside from the EFC, there are net price calculators available online that can help families estimate their college payment and financial aid package before completing the FAFSA and CSS Profile applications.
The EFC computed from the FAFSA is derived from an impartial assessment of the family’s income and assets. The assets are various savings and investment accounts aside from the parents’ retirement savings plans. Parents are expected to pay 6% of their assets and dependent students are expected to pay 20% of owned assets. Parents are also expected to pay 22-47% of their annual income (depending on financial circumstances) while dependent students are expected to pay 50% of annual income. FAFSA offers an annual automatic income allowance (~$6,000) to be excused from the child’s reported income. Independent students who are married or further along in life are assessed differently than dependent students. The CSS Profile’s EFC is somewhat different based on different policies.
Financial gifts from grandparents and other third parties may reduce a student’s need-based financial aid by inflating the EFC. Chart 9 enumerates the ways that cash gifts can affect the eligibility for financial aid.
There are several good ways for grandparents and other third parties to help students prepare for college (chart 10). Some ways may reduce the student’s eligibility for financial aid as just mentioned for chart 9. Other ways help inspire the student to attend college and graduate with a useful education. Contributions to parent-owned savings plans have much less impact than contributions to student-owned savings. Health insurance and student loan payments will help recent college graduates.
Children must learn to spend wisely in order to avoid future financial insecurity
Saving and investing are the best ways to finance goals.Investing starts at home!
Parents and grandparents can help children transform dreams into financial goals and plans.
Effective “ college prep” will create opportunities. “College prep” should be a family commitment AND the high school student’s responsibility.
Education and Investing are the best ways for young people to develop their future. Their success is measured in terms of personal security for a lifetime rather than in millions of dollars. Investing starts with learning how to save for future wants and needs despite many distractions. Family teamwork is an invaluable aid. This Overview is aimed at helping families build a tradition of raising young investors.
Journalists and educators agree that children learn about spending, saving, and sharing money very early in life. Whether their money habits become useful or futile depends on the examples and coaching of trusted adults. Financial education starts at home where family traditions of money management set the standard. If there is no family tradition, then start one. Young investors need a team of parents and trusted adults to provide,
Money management is essential to investing and protecting financial assets such as stocks, bonds, and savings. Building good habits can be a family tradition or a new family experience. Either way, children start forming money habits early, before entering school. Many families teach the wise management of money by encouraging their pre-schoolers to store money in jars (chart 1). Any container would work -envelops, cartons, bowls, socks, etc.- but transparent jars are the favorites.
Spending Jar teaches decision-making and accountability. Children love money and never have enough to pay for everything they want. They should learn to spend wisely, track their expenses and accept the consequences of their choices. Learning to spend wisely can help them avoid future financial insecurity due to fluctuating income and overwhelming debt.
Saving Jar teaches investing. Saving leads to investing and the funding of financial goals. Start by helping children save for short term goals, then encourage them to gradually save larger amounts over longer time periods. Introduce them to the stock market by explaining that their favorite businesses sell shares of ownership. Consider helping them buy stock in their favorite company.
Sharing Jar helps build relationships. Expose children to the needs of their community. Community engagement will cultivate relationships and humane values.
Dreams are gateways to an exciting and prosperous life. Teamwork can help turn those dreams into financial plans for earning and protecting money. The earlier your child’s team begins the process, the better the chance of success.
Dreams can become realistic financial goals. Younger children dream of becoming grown-ups. For example, they wonder what adults do for a living and how parents earn incomes. Older children are inspired by classmates, role models, field trips, activities, etc.
Chart 2 shows examples of goal-starters:
teenagers want expensive things like cars and computers; they should save for it!
young adults think about weddings and buying a home; they should invest in it!
children dream of becoming millionaires; they could invest in a retirement account!
– My granddaughter read a story in The American Girl magazine about saving to become a millionaire. She was ‘hooked’. I discussed the article with her and asked her mother (my daughter) if I could provide some seed money to open an investment account. A year or so later, my granddaughter started earning money as a tutor and used her earnings to open a Roth IRA. She enjoys reading her financial statements and watching her investments grow in value. –
Starting a Roth IRA: www.irakids.com
Chart 3 outlines the sources of income for children.
Unpaid chores are work assignments needed to run an efficient household.
Allowance is a regular gift of money that ‘allows’ young children to practice spending, saving, sharing, and budgeting money.
Jobs are types of labor performed by older children to earn money without a work permit. Not only do jobs enhance wealth but they also improve social skills and help children make decisions about future vocations.
Those who chose to turn a job into their own business are called Entrepreneurs. A successful business matches the skills of the child with the type of job; it also requires planning, organization, perserverence, and reinvestment.
Employment for wages in a regulated business requires children to have a work permit issued by the State.
Investments are a good way to save money for future use. Children have a BIG OPPORTUNITY to create wealth by reinvesting stock returns that will multiply the value of their investment. Chart 4 shows the future value of $1 invested in the stock market when all dividends and capital gains are reinvested in stocks. This mechanism of growth is called “compound interest”.
Dividends and capital gains are types of interest called “stock returns”. The colored dots in chart 4 represent values of compounded returns at selected time intervals. One application of a growth curve is the use of time intervals to help plan big projects. For example, childhood goals of saving for college and retirement fit into uniquely different time intervals:
The growth of $1 to $3 in 18 years is a realistic expectation of saving for college.
The growth of $1 to $30-$114 in 50-70 years is a nice investment for retirement.
Young investors need trustworthy adults to help navigate the red tape of opening a banking or investment account (chart 5). Minors (those youth under the age of 18 or 21 years depending on the state where they live) are unable to open the account without the written consent of an adult parent, guardian, or acceptable attorney. Full control of the account reverts to the young person at the age of majority (age 81 or 21 depending on the state).
Big projects require saving thousands of dollars.
Short term projects include saving for a computer, car, vacation, or wedding.
Long term projects include saving for college, a house, or retirement.
Planning a big project requires setting the goal, estimating the deposits of money, overriding the obstacles, and occasionally reviewing the plan. A simple Retirement plan might be the following:
goal, save a million dollars [this may change later]
deposit 10% of earned income [this will change later]
override obstacles with frugal investing (chart 6) and other protections (chart 8)
review the plan when there are substantial changes of income, expenses, or personal life.
Brokerage firms charge fees for professional advice, trading services, accountants, and safekeeping of securities. The fees are inescapable, but they can be minimized by frugal investing (chart 6).
Automatic reinvestment: Ask your broker to automatically reinvest cash payments from stocks and investment funds.
Infrequent trading: Otherwise, frequent trading (especially small amounts of money on a daily or weekly basis) will dilute investment returns.
Low trading fees: Consult online ratings and reviews of brokerage firms to assess their trading fees.
Dollar cost averaging: The best way of compensating for fluctuations of market prices is to make monthly contributions to the investment account which will then purchase varying numbers of investment units (i.e., shares) depending on the market price. Dollar cost averaging requires a dependable source of money (e.g., payroll deduction, bank account) and a receptive account (e.g., direct deposit plan, 401-K, brokerage).
Taxes reduce the profits from investing. Here are several ways of protecting the profits from taxes:
The Kiddie tax defers some of a child’s investment returns from taxes.
Tax-efficient investments reduce the capital gains & dividends taxes (e.g., growth stocks) or state taxes on bond interest (e.g., muni-bonds).
Federal taxes are not charged on the profits from Roth retirement and Education Savings accounts.
Long term investing: stock prices rise and fall frequently during the short term, but in general the price of a stock will gradually rise in the long term. The young investor can expect a rise in stock price over 30-70 years.
Diversified investments: Some stocks fail to earn returns for the investor. Consequently, it’s a good idea to own several different kinds of stocks to protect the total investment.
“College” is a Big Project
“College” is defined as any 2-year, 4-year, or career school after high school graduation. College prep is a family enterprise that prepares the high school student to negotiate their admission to college. Negotiation is the bargaining process that occurs between the student who wants to attend a desirable college and the college who wants to admit desirable students. The student’s ideal financial goal is to balance the cost of college with family savings and scholarships. Financial aid is only used if needed (chart 7).
TIMELINE FOR COLLEGE PREP
Family starts saving for college 15-18 years early with a “529 Plan” or “Coverdell account” owned by the parents. Grandparents can help fund the plan.
Family has early discussions about college and the opportunities offered by a college education.
Student starts seeking scholarships during the freshman year of high school. Start with the school guidance counselor and librarian. The family can help with the research, proof-readings, practice interviews, travel costs, etc.
Student reduces the cost of attending college by earning college credit during high school.
Family applies for financial aid during the senior year of high school.
FAFSA (Free Application for Federal Student Aid) is required by all colleges.
CSS Profile (College Scholarship Service Profile) is required by colleges that award non-federal aid
Student negotiates the terms of college admission.
Retirement savings plans are increasingly used to supplement Social Security pensions. The 401(k) is the most common retirement savings plan offered by employers. What will happen to the future retirement income of young employees if their Social Security benefits are reduced or their employers suspend 401(k) matching contributions? The employee will then have to make up the savings deficit. It would help if they have their own long-term investing plan for retirement.
Imagine an investment in stocks that grows by multiples of 3, 30, and 90 times the original value during successive time periods of 18, 50 and 67 years. Helping a child make such an investment would help them retire in comfort IF that child learns how to manage the investment throughout adulthood. Homeschooling will help determine how well the youngster ultimately manages the investment.
Many of today’s retirees worry about a shortfall of lifetime savings. Children could avoid this future worry by starting a long-term investment in stocks that accumulates more than two million dollars. Today’s formula is simple: Start early to make regular deposits in a Roth IRA that invests in a broad-market, stock-index fund. Then build the fund with payroll deductions.
Why aren’t there more millionaire retirees? Because of obstacles along the way; college, debt, taxes, and low income to name a few. Dedication and planning are needed to circumvent the obstacles. And here’s an idea for low income families: Help your child open a custodial savings account to accumulate sufficient funds for starting an investment account. Irrespective of family income, parenting skills can instill motivation, participation, and the investment habit in a growing child.