By: Steven Geri, CFA
Any parent is familiar with the life-altering impact of a new baby. Lack of “me” time and sleep deprivation may be the most directly felt impacts, but there is also a significant change to your finances, and it is vital to understand the implications of this major life change. Acting on the following tips might help you tackle the financial implications of parenthood.
Things to Do Now
Maximize Employer Benefits – depending on your employment situation, you may need to make changes to your benefits enrollment and tax withholding.
- Add your new baby to any medical insurance plans
- Consider increasing contributions to any Flex Spending Accounts (FSA) you or your partner may have
- If you have access to a Dependent Care FSA, and plan to hire professional childcare, start funding this account as well
- Update your withholding forms for Federal and state income tax
The W-4 form you filled out when you started with your employer establishes how much of your pay is withheld and sent to the government to cover income tax. By increasing the number of dependents claimed (since you now have a child), you may qualify for lower withholding and therefore, more take-home pay.
Furthermore, if you are not married, having a child may qualify you to file taxes as “head of household,” which may further reduce income tax withholding (assuming you pay at least 50% of the child’s expenses).
Simplify Your Life – one thing all new parents quickly learn is that time is suddenly a scarce commodity. Here are some ideas my wife and I used to simplify our financial life:
- Consolidate accounts (savings, checking, 401(k)s, brokerage)
- Reduce the number of credit/debit cards used (and bills to pay)
- Pay-off any consumer debt or small student loans
- Set up on-line or automatic bill pay for recurring expenses (utilities, cell phone, mortgage, etc.)
By acting on these few basic ideas you can reduce the burden of dealing with your finances in order to free up time to spend with your children.
Protect the Future – none of us likes to think about our own demise, yet once you have children, you want to provide for them in the unlikely event you and your partner die.
- Consider life insurance policies for you and your partner that will provide coverage until your children are old enough to be self sufficient (e.g., through college)
- Draft a will naming a guardian for your children. Depending on the complexity of your situation, you can use a software program or hire an attorney to draft the documents.
Plan for the Future
Children are one of the largest expenses a family will incur. According to a 2009 United States Department of Agriculture study1, the average cost to raise a child born in 2009 from birth to age 18 will range from $206,000 to $476,000 depending on the family’s income. The higher the income, the more families spend on their children. For many parents, this figure is just the beginning, with college tuition bills still to come.
With the arrival of a new baby, there are a few expenses you should immediately count on:
- Basic infrastructure: car seat, stroller(s), crib/beds
- Child care (nanny, daycare, babysitters)
- Medical expenses not covered by insurance
- Smaller, but recurring costs: diapers, formula, clothes
Switching from a two-income to a one-income household? If so, remember your lost income may be somewhat offset by reduced income and payroll tax expenses (Social Security and Medicare). But also consider the potential loss of valuable benefits, including employer retirement plan contributions and subsidized medical insurance. Even if both partners continue working, taking leave when your baby arrives may temporarily reduce your income.
Given the cost of raising a child, parents should spend time analyzing how their “bundle of joy” affects their overall financial plan. Your plan should include a budget and savings goals for both retirement and your child’s education. A simple plan can be developed on a spreadsheet or using Quicken. If your situation is more complex, you might consider hiring a financial planner. Look for one with the CFP® (Certified Financial Planner) designation and who charges an hourly or fixed rate (i.e., does not get paid commission for selling you products). Resources for finding a planner include: www.fpanet.org and www.garrettplanningnetwork.com.
This is also a good time to re-evaluate your retirement savings plan and investments. If you already have a holistic investment plan in place, you will want to reassess it based on a new outlook of your future income, expenses, and your current comfort level with investment risk. For example, if you won’t be saving as much, you might consider a lower risk portfolio since you won’t have new money to invest if there is a market downturn.
If you don’t have a formal investment plan in place for retirement, this is a good opportunity to develop a strategy tailored to your age, investment goals, and risk tolerance. When many people start investing, they put a little money into mutual funds and perhaps buy a few shares of stock; all without thinking about their overall portfolio. If this is your situation, you may want to seek advice in crafting an appropriately diversified portfolio (or use one of the on-line tools available). If you have previously spent time researching investments yourself, consider if this is still how you want to spend your free time. An investment professional can provide an objective third-party viewpoint, an established investment process, and hopefully a broader perspective on investment choices.
If you recently left your job or still have a retirement account with a former employer, consider a “rollover” of your 401(k) to an individual retirement account (IRA). A rollover is the term applied to transferring funds from an employer-sponsored retirement plan – like a 401(k) – to an IRA. In addition to simplifying your life, you generally get a broader selection of investment options (often with much lower expenses) while maintaining the tax-differed status.
Once life starts settling back into a normal routine following the arrival of your child (granted this might take a year or so), your attention will probably turn to the daunting prospect of funding their education.
According to a recent College Board report2, the average cost to attend a private four-year college in 2010-2011 was around $40,000. Assuming a 5% inflation rate on college expenses, that’s a cost in 18 years of around $96,000 per year or nearly $400,000 over four years. In-state public schools are about half as expensive.
As with saving for any goal, the earlier you start the better. The power of compounding returns works wonders ($10,000 earning an 8% return over 18 years turns into $40,000). Before you start socking away money, select the right account type to facilitate your savings. Analyzing all the options for education savings can quickly get complex. A few of the more common approaches are presented here.
Use a tax-advantaged education savings account – There are several types of accounts allowing tax-free earnings if the money is used for education expenses. For example, if you contribute $10,000 today and over the next 18 years the investments grow to $40,000, you can spend the entire $40,000 on educational expenses without owing taxes on the $30,000 in gains. Depending on your state and tax situation, potential savings could be over $10,000.
Probably the two most common options are 529 Plans and Coverdell Education Savings Accounts (ESA). Although these accounts both allow tax free withdrawals, they have a few differences. ESAs allow you to invest in almost any security, much like a normal brokerage account. Contributions are capped at $2,000 per year with lower limits based on income. Although 529 Plans allow larger contributions, investment options are usually limited. Since plans are sponsored by individual states, each state plan is a little different. You don’t need to use your home state’s plan nor does your child need to attend college in the state in which you have the 529 Plan. Program fees charged to administer 529 Plans are generally in addition to fees for similar investments in an ESA.
Open a custodial account in your child’s name – By opening an account in your child’s name you can reap many of the tax savings (due to child’s low tax bracket) without the restrictions. There are no contribution restrictions (beyond regular gift tax limits) and the money does not need to be spent on education. The downside is loss of control by the parent. Once you have funded a custodial account, the money must be spent for the child’s benefit and the money becomes theirs—to do with as they please—once they reach the age of majority.
Of course, you can also save for college using a standard, taxable account. Clearly, this is the simplest option. The disadvantage is you are giving up potential tax advantages. The impact depends on your individual situation and how you invest the money outside a tax-sheltered account.
Although funding your kid’s education may seem like a more pressing need than saving for your own retirement, your family will be well served ensuring your retirement is on track before committing dollars to college.
Putting retirement savings first is simply a matter of alternatives. There is no alternative for funding your retirement. No one is going to loan you money, give you a grant, or award you a scholarship to fund your retirement. If your savings fall short, you will either need to get by on less or continue working past your desired retirement age (if you are able to). Conversely, there are many ways to pay for college. Beyond attending a lower cost school to reduce the burden, there are Federal loan programs, grants, part-time jobs, and scholarships to help provide funding.
She who fails to plan, plans to fail
Spending a few hours understanding the financial implications of your new life is time well spent. Your family’s saving and investment plans should reflect your new reality. Take full advantage of your employer’s benefit package and ensure taxes are withheld correctly. Establish a good safety net in the event of your untimely demise. Free up time by reducing the burden of managing your finances. And finally, although you want to save for your child’s education, don’t sacrifice your own retirement aspirations in the process.
1 Lino, Mark. (2010). Expenditures on Children by Families, 2009. U.S. Department of Agriculture.
2 College Board’s Trends in College Pricing 2010
Steven Geri, CFA is the founder of InvestSimply LLC (www.investsimply.com), an online investment advisory firm focused on crafting and managing investment portfolios for individuals and families. He writes a blog on investing and other financial topics at www.investsimply.com/blog. He lives with his wife and two daughters in San Francisco.