As originally published in Essential Living Maine, September/October 2016
Being a parent is tough on so many levels – there never seems to be enough time, money or sleep. With kids at home come so many important priorities pulling at ourselves and our resources. If someone gave you a thousand dollars right now, you could probably think of seven different places it could go – and that’s before even getting to the fun stuff, like vacations. Besides saving for retirement and college educations, you might have the dream of buying a camp on a lake, paying off car loans or student loan debt, or building up your “life happens” fund for those extra things that seem to consistently come up – like Christmas gifts, car repairs, and all the extra expenses that come along with kids – ballet tuition, sports equipment, clarinet lessons. Maybe you have to paint the house or get a new roof soon. The trickiest part of being a parent in a financial sense is balancing all of those priorities.
First things first: Saving for retirement
Retirement is the most important thing to save for, whether you are a parent or not, for so many reasons:
• There are very few sources of income other than what we put away for ourselves.
• Retirement can last 30 years or more and you need to have enough to live comfortably.
• You can borrow for college or a second home or a boat, but you can’t borrow for retirement.
• You don’t want to depend on your children to support you in retirement.
So, how do we plan for it?
Starting early and saving steadily make a big difference. If you’ve been living well below your means and saving 12-15% of your income starting early in your career, you will probably have enough to live comfortably in retirement. If you start later, you might have to save more aggressively. The younger you are when you start saving, the more you can take advantage of the incredible power of compound returns – simply put, money earned on prior earnings. If you contribute small amounts to an account for thirty or forty years, the balance in that account will grow to many times the amount you contributed.
If you’re eligible for an employer-sponsored retirement fund, such as a 401(k) or a 403(b), consider taking advantage of it, particularly if your employer offers some kind of matching contribution. The main advantage of such a plan – other than decades of tax-deferred earnings – is that because the money comes out of your paycheck, it’s easy to set it up and then leave it to grow. You’re paying yourself first – the money never comes into your checking account, so it’s not up to you to make sure it makes it into your retirement account. It’s out of your hands.
If there’s no employer match, or if the plan doesn’t seem worthwhile – maybe it has high fees or limited fund choices – consider opening a traditional IRA or a Roth IRA. You’ll get an immediate tax deduction for contributions to a traditional IRA and years of deferred taxable growth; for a Roth IRA, you won’t see a tax deduction now, but you’ll have years of tax-free earnings. That’s right – you pay no taxes ever on money earned within a Roth IRA, as long as you are at least 59 ½ at the time of the withdrawal and you’ve had the account for at least five years (there are exceptions to this rule for certain circumstances, such as first-time home purchase and college expenses).
Saving for college
If you have children, you presumably would like them to get a college education. 529 plans are the best way to save for college. There’s no deduction from your federal taxes (or Maine taxes, starting in 2016) for contributions to the account, but withdrawals are entirely tax-free as long as you use them for qualified expenses. Qualified expenses include tuition, room and board, computers, books, and supplies.
If your child gets a scholarship and won’t need the funds in the account, you have three options:
• You can save the money within the account for later expenses, such as graduate school;
• You can transfer the account to a different beneficiary, or
• You can withdraw the money penalty-free up to the amount of the scholarship. You still pay taxes, but you don’t have the 10% penalty – it becomes a tax-deferred account, rather than a tax-free account.
If you have an emergency and need the funds for something besides education expenses, you can withdraw as much as you need at any time, but you will pay tax and penalties on the earnings portion of the distribution.
There are several grants available for Maine residents if you invest in the state’s 529 plan, known as NextGen, which is run by the Finance Authority of Maine.
• A $500 initial grant for all babies born in Maine starting in 2013; or $200 for older children to open a new account
• An 50% matching grant on all contributions, up to a limit of $300 per year
• A one-time $100 grant for setting up automatic contributions to the account
Balancing college and retirement
It’s important to make retirement savings your priority. At the very least, contribute enough to maximize any employer match. Keep in mind that because 401(k) contributions are made with pre-tax money, adding to your 401(k) doesn’t reduce your paycheck dollar-for-dollar – for every $100 you contribute, it might reduce your paycheck by only $70 or so, depending on your tax bracket. As your income increases, you can incrementally increase your 401(k) contribution. For example, if you get a 3% raise, consider increasing your 401(k) contribution by 1% – you’ll still see an increase in your take-home pay, and that tiny amount will make a big difference in your account once you need it in twenty or thirty years.
Once you’re saving 10-15% of your income – including any employer match – for retirement, you can start seriously saving for college. Set up a 529 plan for each child as soon as you can manage it, and try to put in a small amount of money each month – hopefully enough to maximize the grants available. It may not add up to a lot at first, but you can always increase it as your income increases. Save as much as you can for college without jeopardizing your own retirement.
What if I have debt as well?
How to handle debt depends on the situation. If it’s high interest debt, you might want to aggressively pay it down before you start saving for college, but think hard before sacrificing your retirement savings to pay down debt. It may make sense to do so if the debt can be repaid quickly – within a few months – but you don’t want to lose five or ten years of retirement savings; that will have a serious impact on your accounts when you need them in retirement. Low interest debt (like mortgages) should not be prepaid unless you have extra money laying around and really want to be debt free. If you’re maxing out your 401(k) and putting lots of money away for college, then you might consider paying down your mortgage.
The main thing in thinking about your family’s financial future is to have a plan, so that you’re exercising some control over your choices and you have a sense of how the future will look for your family. If you’re thinking about it now, you’re on your way to getting there, and you’re a step ahead of many parents.
Allison V. Bishop, CPA, is a personal finance coach in Portland, Maine with 18 years experience as a CPA. She seeks to help her clients make conscious decisions around their money in order to reach their financial goals. Her website is allisonbishop.com.