The Money Class

by Suze Orman

  THE THREE-OPTION APPROACH

  Sit down with your child and explain that the annual birthday and holiday money they receive is theirs to handle, but that they must tell you with each gift the how and why of what they choose to do with the money. You will frame this conversation by laying out three possible options:

  They save it for a future goal.

  They spend it.

  They share some of it by making a charitable donation.

  I would refrain from telling them what you think the proper split of the money should be for all three. And hey, if they look at you and say they want to use 100% to spend, well, Mom and Dad, welcome to your uncomfortable truth. You have some parenting to do on the importance of saving and giving. You really need to focus on what’s going on here. As I noted earlier, kids don’t simply do as you say, they often do as you do. If your child wants to only spend, I encourage you to consider whether your behavior has on some level “taught” them that this is acceptable. Children, of course, pick up many cues from outside the home—they’re influenced by their friends, by what they see on television or online or in magazines—but what they experience at home is probably most influential of all. I am asking you to question whether your own spending habits and behaviors might be sending the wrong message. If you don’t like what you see and hear as you start to have these conversations, it’s time to recognize the signals you have put out for years that may have created this mindset in your child.

  Ultimately I hope your child soon gets into a rhythm where she wants to use her money to save, spend, and donate. All these are important. I’d rather see a child spend some of their money than put 100% in savings or give it all away. The goal here is to teach your child how to handle money, and all three options have a place in our lives.

  I want to make sure you really understand the importance of giving your child total control of a spending account: If you prevent your child from being able to use some of their money, to touch it—physically—and use it to buy things—yes, wants are okay!—they will just end up resenting the process and probably rebel when they get older by overspending. Help them learn how to spend responsibly—in moderation—today. That will serve them well as adults.

  Some tips on each option:

  • Create an incentive to save. There is no question that the delayed gratification of saving for a future goal is hard enough on adults—just look at how many people are not saving enough for their retirement—but you should multiply that difficulty factor by 10 to capture the challenge it is for children. When you suggest to an 8-year-old that he should save money for when he is 18 or 22, you are asking him to set a goal that is longer than he has even been alive! That’s not exactly an easy concept to grasp. I think you should encourage your child to set short-term goals. No longer than six months, at the start. That’s how you keep your child engaged and enthused. That’s how you convey the pleasure of savings.

  Offering a matching contribution can help a child stay focused on a long-term goal. Just like with your 401(k), you might agree to chip in 25 cents or 50 cents for every dollar your child agrees to set aside in a savings account for a future goal you are all agreed on. And perhaps you offer an even higher match rate for money they set aside for charitable donations. That’s a clear telegraphing of what you value most.

  • Spending: Maybe your child will spend it carefully on treasured items. Maybe it will be thrown away on things that quickly lose their allure. You are not to judge, guide, or control. This is a learning process. We learn as much from our mistakes as our triumphs.

  • Giving: Ideally your child is already familiar with the concept of giving; as I explained earlier, from a very young age I encourage you to have your child donate unused toys or outgrown clothes to your local charities; have the children be part of the actual transfer of goods. That tangible experience is how you start the conversation simply by doing. Once you introduce the concept of giving money to charities, help them understand their options. You can offer guidance, you can explain how they can help people close to home or on the other side of the world, but ultimately let your child decide.

  KEEP A MONEY JOURNAL

  I also encourage you to have your children keep a journal of how they choose to use their money. Every time they put money into a savings account, spend it, or donate it, I want them to record their thoughts and feelings in the moment. Be sure to sit down and review the journal after six months or a year. The journal is a written record of your child building a dream of her own. In it, she is beginning to explore and experience what it means to make a choice to consciously spend less than you have, to take pleasure in saving, as well as to enjoy spending.

  When you are reviewing the journal you might also ask your child to reexamine her purchases. For example, if your daughter spent $35 on a video game eight months ago, ask her if she had it to do over again, would she rather have that video game or the $35 in cash. This conversation will lay some important groundwork for future conversations. In the coming months when your daughter is contemplating a purchase, you can ask her if she thinks this will be a purchase she will love or regret six months from now. Don’t say it in a judgmental way. Your goal here is to simply guide your child through a thought process, not to impose opinions of your own.

  LESSON 3. HOW TO CREATE A FINANCIALLY HONEST COLLEGE STRATEGY

  College can be one of the best investments you and your child will ever make. The lifetime earnings advantage for a college graduate is about $1 million compared to a high school grad. Moreover, our economy creates more opportunities for college graduates. In late 2010 the unemployment rate among people 25 years or older with a high school degree (and no bachelor’s degree) was 10%. The unemployment rate among college graduates was 4.4%.

  You will get no argument from me that college matters. But there is a very important truth I need each and every family to stand in: Cost matters. Putting your children through college was a cornerstone of the American Dream, particularly for immigrants and first-generation children. But the New American Dream cannot simply be, I want my children to graduate from college. It must be, I want my child to graduate from a college that is affordable for my child, and for me. The fact is, most families don’t stop to think through the cost part. Oh sure, you know full well that it is a lot more expensive than you can afford to pay out of your savings. But that hasn’t made you truly cost sensitive. You still tell your kids to set their sights on any school and you will figure out the money later. And then you end up making a mess of your other important dreams. You stop saving for retirement, or worse yet, you use money in your retirement accounts to pay the college bills. That is not standing in your truth. It is incumbent on you when your children are young to develop a strategy for how as a family you can send your children to college without compromising your other financial goals.

  WHO SHOULD SAVE FOR COLLEGE?

  Before you start to save one penny for a child’s future college costs, I insist that you have the following financial priorities taken care of:

  You do not have credit card debt.

  You have an eight-month emergency savings fund.

  You have a term life insurance policy.

  You are saving for retirement; aiming to set aside 15% of your gross salary.

  Until all of that is in place you are not to think about saving for college. Many of you have heard me say this repeatedly over the years: There is financial aid for college. There are loans for college. But there is no aid or loans to help you in retirement. There is no aid if you run into a rough patch and you do not have sufficient funds in an emergency savings account to navigate your way out of trouble.

  Your first order of business is building a solid financial foundation for your family. Only when that is in place can you begin to save for college. And know full well that there is absolutely no shame if you are not able to save. As I explain later in this chapter, there are affordable ways for your child to obtain a quality education. Trust me on this one: W
hat your kids really need from you is the peace of mind that you have your own retirement plan in place so they will not be asked to support you later on.

  THE BEST WAY TO SAVE FOR COLLEGE: 529 PLANS

  If you have the ability to save for college, the best way to save is by setting aside money in a 529 college savings plan. The two big advantages of a 529 plan are a series of valuable tax breaks and the fact that just a small percentage of assets (less than 6%) inside your 529 account will be used by college financial aid offices when evaluating your family’s request for financial aid.

  529 Plan Basics

  A 529 plan allows anyone, regardless of their income, to contribute money into a special savings account that works much like an individual retirement account. There is no annual limit to what you can set aside; the lifetime savings limit is typically $300,000. You choose the investments for the account, and while the money is invested in the 529 plan there is no tax bill. Withdrawals from the plan that are used to pay for “qualified” school expenses will be tax-free. Depending on the state you live in and the specific plan you choose, you may also be able to claim some of your contribution as a deduction or credit on your state income tax return.

  A 529 plan is, in my opinion, a better way to save for school than an UGMA/UTMA, a Coverdell Education Savings Account, or a Roth IRA.

  UGMA/UTMA

  These are custodial accounts that adults set up for minor children, as permitted by the Uniform Gifts to Minors and the Uniform Transfers to Minors acts. The child is in fact the “owner” of the account. There are tax benefits to these accounts, but I do not like them for college savings for two important reasons: Once a minor child reaches the age of 18–21 (depending on your state), he or she has complete control over the assets. If your child decides to take the money and head out for a global adventure, you have no legal right to stop her. The other problem is that UGMA and UTMA assets are treated differently than 529 assets when assessing your family’s application for financial aid. Less than 6% of assets held in a 529 plan owned by a parent (for the benefit of a child) are used to compute a family’s eligibility for aid. By comparison, 20% of assets owned by your child—such as an UGMA or UTMA—are factored into the calculation. In other words, money owned by a child will reduce your eligibility for financial aid, or the level of aid your family qualifies for.

  COVERDELL EDUCATION SAVINGS ACCOUNT

  There is nothing inherently wrong with a Coverdell (previously known as an Education IRA) but they don’t offer any major advantages over a 529. As with a 529, money you invest in a Coverdell grows tax-deferred and withdrawals will be tax-free if used for qualified education expenses. While there is no income test for making contributions to a 529 plan, married couples with income above $220,000 (or $110,000 for single tax filers) are ineligible to contribute to a Coverdell. Moreover, the current annual maximum contribution to a Coverdell—effective through 2012—is just $2,000.

  ROTH IRA

  It is absolutely true that a Roth IRA can be an interesting way to pay for college costs. No matter your age, money you originally contribute to a Roth IRA can always be withdrawn without penalty or tax. And if you withdraw any of the money you have contributed before age 59½ to pay for college costs, you will not owe the typical 10% early withdrawal penalty, though you will owe income tax on the earnings. (There are special rules for Roth conversion IRAs; see this page for details.)

  The problem with using a Roth IRA to pay for college costs is that it can compromise your retirement planning. A Roth IRA should not be asked to do double duty: It cannot be a college fund and a retirement fund. If that’s your strategy you and I both know what is going to happen: Because college costs occur before retirement it is likely you will sharply reduce, if not use up entirely, the money in the account, leaving you high and dry for retirement. You need to resolve not to allow your retirement to be derailed by a competing demand that chronologically happens to occur first; chronologically is not how I want you to prioritize. As I explain in the class on retirement planning in your 20s and 30s, a Roth IRA is my favorite type of retirement account. I just want you to use it for retirement, first and foremost. Now, that said, if you have set up a Roth IRA with the explicit purpose of using it for college costs, that is a different matter. In that instance using your original contributions to the Roth to pay for school—they are not taxed nor do you owe any early withdrawal penalty—is a fine strategy. Just remember to leave the earnings in the account and use that for your retirement. If you were to make an early withdrawal of earnings from a Roth you might be hit with tax.

  But please stand in your truth. If you know deep down that the Roth IRA you have is needed first and foremost for your retirement, please do not use it for college.

  WHAT IF YOUR CHILD DOESN’T NEED THE 529 MONEY?

  There are some important rules you need to understand in the event your child chooses not to go to college or is awarded so much in grants and scholarships that you don’t need all the money you have set aside in a 529 plan.

  You can transfer the account to another beneficiary. Most 529 plans allow you to switch a beneficiary to another family member, including siblings (and step-siblings), nieces, nephews, first cousins, and in-laws. You could also name yourself the beneficiary and use the money to go back to school.

  You can withdraw the money for noneducational purposes. There is no penalty or tax on money you contributed to the account, but if you withdraw earnings from the account and that money is not used for education purposes, it will be subject to income tax as well as a 10% penalty.

  HOW TO CHOOSE THE BEST 529 PLAN FOR YOUR FAMILY

  There are two flavors of 529 plans: direct sold and advisor sold. I only want you to consider direct-sold plans. The fees for advisor-sold 529 plans are too high, and often the advisor-sold lineup of investment choices does not include low-cost index funds. If you want the advice of a trusted financial advisor on how to handle your college savings, pay the advisor a separate flat fee for his work rather than have him guide you into expensive advisor-sold 529 funds. If your advisor only uses advisor-sold 529 funds I recommend you find a new advisor who is not dependent on commissions. At NAPFA.org you can search for local advisors who work on an hourly or fee basis.

  TIP: I highly recommend every family spend some time at Savingforcollege.com. It has wonderful articles and tools to help you make an educated decision about the best 529 plan for your family. Here are some important issues to consider:

  Compare your state plan to an out-of-state plan. Every state offers its own 529 savings plan. But please understand that you are not obligated or required to stick with a plan offered by your state. You can in fact invest in any plan from any state and use your money to attend any school in any state. The sole advantage of sticking with your state’s plan is if it offers valuable tax breaks or other incentives to residents. For example, contributions you make to any 529 plan are not eligible for a federal tax deduction. But some states allow in-state residents to claim a state tax deduction or a credit on their contributions. That said, there is often a limit on the value of the tax break, and in some states there is an income cutoff to be eligible for the tax break.

  At Savingforcollege.com you can find state-by-state information on the tax treatment for in-state residents. This is obviously an important consideration when choosing a 529 plan, but it should not be your only consideration. It makes absolutely no sense to sign up for an in-state plan that has high fees and expensive mutual funds. It can make more sense to pass up the tax breaks and choose a plan offered by another state that has lower fees and better investment choices.

  Focus on fees. Similar to how a 401(k) works, when you contribute to a 529 plan you will choose from a menu of investment options. Typically these are mutual funds. Every mutual fund has an embedded annual fee called the expense ratio. This can be as little as 0.20% or so, or it can be 1.5% or more. The more you pay in fees the less your money will go toward paying for college. Before you sign up
for a 529 plan make sure it offers mutual funds with annual expense ratios below 1%, and the lower the better.

  Check for conservative investment choices. As I explain below, by the time your child is a senior in high school you will want to have the bulk of your account in conservative investments; it is too risky to have your money invested in stocks when you know you will need that money in one to five years. Not all 529 plans offer a money market or certificate of deposit (CD) option. Please stick with a plan that gives you the option of pulling out of stocks as your child nears college age.

  Understand beneficiary transfer rules. If you have more than one child and you anticipate you may want to transfer the beneficiary from one child to another, make sure your plan allows this move.

  HOW TO INVEST YOUR 529 PLAN

  Many parents with children in high school learned a very painful lesson during the 2008 financial crisis when their 529 accounts lost 30% or more because so much of their account was still invested in stocks. Given that they had just a year or two before they would need to start tapping their funds to pay the college bills, they should never have left so much in volatile stocks. And what was most alarming was that many of these parents had left it to the plan to make the decision about how much to have in stocks versus bonds and other conservative investments. A popular feature of many 529 plans is an age-based fund that leaves it to the plan sponsor to alter the mix of stocks and bonds based on the child’s age. This works just like a target retirement fund; the idea is that as the child gets closer to college, the portfolio will become more conservative. In fact that’s how many plans work, but not all. The bottom line is that you cannot blindly rely on anyone to make your investment choices for you. You are responsible for making sure your money is invested in a way that makes sense for you.