We all want what is best for our children and grandchildren. We want them to develop into kind, capable and responsible people. More than anything, though, we want them to be happy.
With study after study showing that money is one of the leading causes of stress and unhappiness for people, what better way to positively influence their future happiness than by giving them a financial head start today. And no, I don’t mean handing over a pile of cash to them. I’m talking about precise steps you can take, in combination with steps taken by your children and grandchildren, that will start them down the path of greater financial success and, as an extension, greater happiness.
Open a Roth IRA
Opening a Roth IRA may be one of the most financially effective things you can do for a child or grandchild. The tax benefits of a Roth IRA often suit their situation perfectly. Since contributions are after-tax, gains accumulate in the account tax-free. This tax benefit, coupled with the young age of the child, is what makes a Roth IRA a truly remarkable opportunity. The gains will have decades to grow without $1 of tax being due on that growth. Keep in mind, though, the child must have earned income in order to open a Roth.
If a 16-year-old invests $5,000 per year, earning 7% until age 65, then at age 65 she will have $2,027,000.
You can see how the decades of growth helps create a sizable account value, before even factoring in the tax benefit. Out of that balance, $245,000 consists of the annual contributions with the remaining $1,782,000 being investment gains, which again are tax-free.
Consider opening a Roth IRA for your child once they start their first job and have earned income, which can come from W-2 employment or from self-employment, such as mowing grass or babysitting for the neighbors. If they have earned income, they can contribute to a Roth IRA, as long as the total annual contributions do not exceed the lesser of their earned income or the contribution maximum ($6,000 in 2020). For children, age is not a consideration at all. In fact, a 2-year old who is paid to be in a commercial is eligible for a Roth IRA. With children under age 18, parents can open a custodial Roth IRA, managing those funds on their behalf until the child is 18.
Another example: Business owners can hire their children for the family business, paying them a reasonable rate to perform a legitimate job. This can open up tax savings scenarios for the business owners, as they could receive a tax deduction on the child’s wages and be exempt from FICA taxes. At the same time, it allows the child to earn income that qualifies for a Roth IRA contribution. Exemption of FICA taxes is available as long as the child is under age 18 and for businesses that are structured as a sole proprietorship, single member LLC, or partnership where the parents are the only owners.
Build a Credit Score
While a Roth IRA will start them down the path of saving, you can also take proactive steps with them in managing their future debt. If your teenager is mature enough to understand the consequences of misusing a credit card and you have a good credit score, you can consider adding them as an authorized user on your card.
While this takes a level of trust, the benefits for your child are numerous. For one, it will introduce them to the tools needed to handle credit responsibly. Since they will use credit throughout their lives, it makes sense to start the learning process while it can still be monitored by the parents. Also, as an authorized user, they will be building up their credit score based on your timely payments.
Then, as they transition into adulthood, they will be in a better position to be extended financing — and at better rates — for purchases, such as a car and house. They will also have an easier time getting their own credit card. Once they turn 18 and are eligible for their own credit card, having a higher credit score will more quickly get them approved for an unsecured credit card that offers reward perks, instead of having to settle for a no-frills secured credit card.
As authorized users, they will receive their own card, but it’s still the primary cardholder’s responsibility to pay the bill each month. Those payments are then reflected on the authorized user’s credit score. And if you are hesitant, note that it is possible to add them as an authorized user and not tell them or share a card until you feel they are ready.
Each card company is different in how they treat authorized users. Most have minimum ages, some have costs to add one, and some let you place monthly spending limits for authorized users. Calling your card company will help figure out how they approach the subject specifically.
Manage College Debt
It’s no secret that student loans have become a real problem for many people, with high loan amounts preventing them from getting a start on financial success. While college, overall, is still a good investment, it comes with notably different costs from college to college and easy-to-obtain loans that can cause the total bill to balloon by graduation time.
Compounding this is the fact that most students making these college decisions are 18 years old with little real-world financial exposure. Because of this, before your child or grandchild enters college, there are steps you can help them take to manage this future debt.
The first step is taking note of what income sources and assets are currently available to pay for college, along with what the graduate’s expected income in their field will be upon graduation. It is these sources, most likely, that will be used to pay off the college loan. A rule of thumb is that college debt should be limited to close to 1x expected income upon graduation. At this level, the loan should be able to be comfortably paid off in 10 years.
Similar to any big purchase, search colleges that are within this budget. The attention should be on the out-of-pocket cost and not the “sticker price” of the college, as most offer generous financial aid. CollegeBoard.org (opens in new tab) is a great resource for information on the financial aid offered at different schools, and each school’s website will have a “Net Price” calculator to help calculate the out-of-pocket cost. You can encourage your child to save more by looking into co-op programs, work study programs, local and national scholarships and grants, and filing the FAFSA form as early as possible to maximize the amount of aid offered.
Talk About Finances
Simply talking to your children about finances may help them get ahead in life. This does not have to involve a deep discussion on the particulars of taxes or retirement accounts. It’s more an opportunity to instill good values in them by explaining to them the rationale behind some of your financial decisions.
Most experts say that children can start to understand where money is being spent at around age 6. When they ask for a toy, you can explain to them that money is being spent instead on groceries to give them an introduction into “wants” versus “needs.” Telling them to save their allowance for the toy will show them delayed gratification and savings.
As they get older, your financial adviser should be open to meeting with them to discuss more hands-on planning. Some of my favorite meetings are with my clients’ children, discussing the ways we can start them on track with their finances.
Opening them up to financial discussions throughout childhood will make them more comfortable to talk about finance, learn about finance, and to think about the pros and cons of each decision before they make it.
As you can see, a financial head start for your children and grandchildren does not have to involve gifts of money. Opening a Roth IRA at a young age, building credit early, managing college debt, and having good financial values are four important functions that you can help them with that will give them a financial head start with less financial stress.
Kevin Webb is a financial adviser, insurance professional and Certified Financial Planner™ at Kehoe Financial Advisors (opens in new tab) in Cincinnati. Webb works with individuals and small businesses, offering comprehensive financial planning, including Social Security strategies, along with tax, retirement, investment and estate advice. He is a fiduciary, ensuring that he acts in his clients’ best interests.
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