Financial Makeover: Advice for New Parents

— -- Q U E S T I O N: My husband and I have a 3-month-old daughter and her childcare expenses; plus mortgage, car, appliance, school loan and utility payments. We don't have credit card payments because we consolidated our debts and paid them off in full a year ago. The car and appliance purchases were necessities, as we had to replace nonfunctional items with working ones. What should we be doing to prepare for the future?

A N S W E R: Angie and Terry are in their early 30s with a newborn child and are facing a wide array of financial planning issues. They want to establish a college fund, begin building a retirement nest egg, and possibly repay some of their student, auto and consumer debt … all without having to take on a second (or third!) job.

They suspect that they need to do some tax planning to make sure that they're taking advantage of tax-saving opportunities. Moreover, since they are new parents, it's important that they think about purchasing sufficient life insurance and preparing a basic estate plan.

Angie's and Terry's situation is not uncommon, and with a little planning they can be on their way to securing their financial future.

Expect the Unexpected

Unexpected expenses and events can wreck even the best financial plan, so before thinking about long-term goals such as retirement or college education for their daughter, Angie and Terry need to ensure that they're prepared for the unexpected. Angie notes that they recently had to replace several appliances, and they financed the purchases with credit. Unfortunately, consumer credit often carries a very high interest rate and should generally be avoided. Accumulating a cash reserve equal to three months of take-home income would cover most of life's unexpected expenses (such as new appliances or car repairs), without having to resort to expensive consumer credit. They should set aside this reserve in a bank savings account or money market account, where they can easily access the money in a pinch.

Angie and Terry own their home, which may be an additional source of liquidity if they've owned it awhile and have some equity. They should consult with their bank or mortgage lender about establishing a home equity line of credit, a relatively low-cost credit line that they can draw up to pay for large unexpected expenses and then pay down over time. (Think of a home equity line as a credit card that's tied to your house.) At current rates of as low as 4 percent to 6 percent, home equity lines can cost much less than most consumer debt, which often carries interest rates of 18 percent or more. Moreover, home equity interest (on credit up to $100,000) is tax-deductible, unlike interest paid on credit cards and automobile loans; consequently, if they have sufficient equity to qualify for a low cost credit line, Angie and Terry should consider paying off higher-cost automobile and appliance loans with a home equity loan.

One word of caution: Home equity lines, like credit cards, can make it very easy to spend on frivolous or unnecessary expenses. Because a home equity line is secured by your home, missing payments can lead to your home being repossessed; consequently, the credit line should generally be used only to bridge temporary cash flow shortfalls caused by large, necessary expenses. Fortunately, Angie and Terry appear to use credit very responsibly, so they're not likely to have a problem.

Thinking About the Unthinkable

No one likes thinking about their own mortality, but now that Angie and Terry have a child it is very important for them to address the question of what would happen to their surviving family members if one or both of them died prematurely. They'll want to make sure that any surviving spouse and young children have adequate resources to maintain their current standard of living should one spouse die. For many families, this means purchasing life insurance to supplement the savings and investments that they have already accumulated.

Many people determine how much life insurance to carry based on general "rules of thumb" (e.g., 10 times salary) that can result in their being precariously underinsured or, alternatively, paying for insurance that they don't need. While using a rule of thumb is better than having no insurance at all, a better solution is to instead engage a local Certified Financial Planner (CFP) to conduct a detailed analysis that reflects their specific plans in the event that one spouse dies. The analysis will reflect, for example, the surviving spouse's plans for working and possibly relocating after the death of one spouse, as well as an estimate of the survivor's living expenses and children's college costs. Obviously, this type of detailed analysis yields a more accurate result than relying on a simplistic rule of thumb.

This analysis will likely cost a few hundred dollars, but it will result in an insurance plan tailored to their specific survivor security objectives. They can locate CFPs in their area at www.fpanet.org. Alternatively, they could work via telephone with a financial planner at Vanguard Investments (vanguard.com) to prepare a comprehensive survivor security analysis.

Once Angie and Terry determine how much life insurance they need, they have to decide what kind of policy to purchase. "Term" life insurance is very inexpensive for young, healthy people like Angie and Terry, so purchasing sufficient coverage won't be a large drain on their cash flow. They should avoid "permanent" life insurance policies that have a savings component, as they are significantly more expensive than term insurance. Moreover, Angie and Terry have many more attractive places to save money (e.g., Roth IRAs, 401(k) plans, 529 plans) than in a permanent insurance policy.

Importantly, Angie and Terry should re-evaluate the adequacy of their life insurance coverage at least every five years, or sooner if they experience a major change in their circumstances (e.g., buy a larger home, have another child).

While most families purchase insurance coverage to provide for their survivors, many forget about another very important component of protecting their family: estate planning. Without an estate plan, state laws determine the disposition of your assets and, if both spouses die, the guardians of minor children. In many cases the guardians selected by the state would not be the same ones selected by the parents. Consequently, if Angie and Terry don't already have an estate plan, they should contact an attorney soon to draft wills that name guardians for their child and specify how their property is to be distributed.

Debt vs. Investment

After establishing an emergency reserve and making sure that survivors are protected, Angie and Terry can focus on achieving their important long-term goals of assisting their daughter with college expenses and their eventual retirement. They are very wise to begin saving for these goals so early in life, since even a small amount set aside today can compound into a very large sum over several decades.

Before committing to a saving plan, however, Angie and Terry should examine their various loans and determine whether it makes sense to pay those off before starting to save. They currently have a number of outstanding loans - a home mortgage, an automobile loan, student loans, and consumer loans used to finance new appliances. Whether to pay these loans off or keep them for now depends on how much the debt costs relative to what their investments can earn over time.

Home mortgage debt is generally pretty inexpensive, largely because the interest is entirely tax-deductible. Likewise, student loan interest is also tax-deductible for couples earning under $100,000. If, for example, the interest rate on their student debt is 7 percent and Angie and Terry are in the 25 percent federal tax bracket, then their after-tax cost of the debt is only 5.25 percent (7 percent x 0.75 percent = 5.25 percent).

It's likely that their retirement funds and college fund will earn a return greater than 5.25 percent over time, so it would make sense for them to direct any additional cash to these investments instead of paying down low-cost mortgage and student debt. The automobile and appliance debt, in contrast, may have a high enough interest rate that it makes sense to repay those loans before investing for long-term goals. For example, if their appliance loan bears a high 10 percent interest rate then they should consider repaying this loan (or paying it off with a home equity line, as discussed above) before investing for their long-term goals, since repaying the loan is equivalent to a riskless 10 percent return.

Finally, Angie and Terry would be wise to talk with their banker to see if they can reduce their interest rates even further by refinancing their home mortgage and/or consolidating their student loans. If their mortgage rate is much above 5.75 percent then they should consider refinancing, which will lower their payments and free more resources for investment toward their long-term goals.

Saving for College

Angie's and Terry's daughter is only 3 months old, so they are in a good position to begin saving for her eventual college education expenses and maximize the benefits of many years of investment growth. According to the College Board (www.collegeboard.com), a public four year university in Kansas costs about $14,000 annually for in-state tuition and room/board. Assuming a 6 percent tuition expense inflation rate and a 7.25 percent tax-free investment return, Angie and Terry need to set aside about $300 monthly to fund the projected education costs. If their daughter attends a nearby college and can live at home then they could set aside even less money for school. Click here for college calculator

Once they've established a savings target, Angie and Terry need to decide where to invest their savings. Fortunately, they have many very good college savings options to help them reach their goal. Coverdell Education Savings Accounts and state-sponsored 529 plans both enable parents to accumulate tax-free savings for college expenses. The Money Makeover article "529 Plans"

has more detailed information on these college savings options, as does the website www.savingforcollege.com.

Most 529 plans have an "age-based" investment option that automatically shifts the account allocation from more volatile stocks to relatively stable bonds as the child nears college age. This investment option is ideal for people who want to put their account on "autopilot."

Saving for Retirement

After funding an education account each month, Angie and Terry can deploy any remaining excess cash flow toward retirement savings. If their employers offer a 401(k) matching contribution then they should contribute at least up to the level required to receive the entire match. Many 401(k) plans contain an investment option that includes a broad mix of U.S. stocks, overseas stocks, and bonds. These "all-in-one" funds are often well suited for investors who prefer to purchase a well-diversified portfolio in a single fund.

After getting the entire matching contribution, Angie and Terry should direct any additional retirement savings (up to $3,000 each in 2004) to Roth IRAs, which grow tax-free. They can establish Roth IRA accounts with most mutual fund families, but they should pay particular attention to Vanguard (800-662-7447; vanguard.com), which offers several low-cost, broadly diversified mutual funds that are suitable investments for reaching their long-term goals. For example, the Vanguard Life Strategy Growth fund, which invests in a diversified pool of U.S. stocks, overseas stocks, and some bonds, is an appropriate fund for their Roth IRA investments.

If Angie and Terry have additional capacity to save for retirement after funding Roth IRAs, they should then continue deferring as much as they can into their 401(k) plans.

Pay Yourself First!

The most important habit of successful savers is that they pay themselves first. One of the benefits of the education and retirement savings options discussed above is that savers can have money automatically deducted from each paycheck (or their checking account) and deposited into each account. Another tried and true way of increasing one's savings over time is to commit salary raises, bonuses and tax refunds toward savings or debt reduction instead of increased spending. These are excellent techniques for maintaining the discipline needed to fund your financial goals. Most of us don't miss the money and learn to live on what remains.

Help from Uncle Sam

Uncle Sam offers numerous tax deductions and credits that benefit young families, and Angie and Terry should make sure that they take advantage of all opportunities for tax savings. Some key opportunities for reducing their taxes include:

Child tax credit: At their income level, Angie and Terry can receive a $1,000 reduction of their taxes because they now have a child. Childcare tax credit: If Angie and Terry incur childcare expenses, they can probably receive a refund for a portion of these expenses. At their income level, they can probably receive $600 back from the IRS (couples earning less could receive up to a $1,050 tax credit for 1 child, or up to a $2,100 credit for 2 children.) Flexible spending plan: If Angie's or Terry's employer offers a flexible spending account, they may be able to set aside a portion of their salaries pre-tax for expected medical expenses and childcare expenses. Itemized deductions: Angie and Terry should consider itemizing their tax deductions, allowing them to deduct mortgage interest, state tax payments and charitable contributions, as long as the sum of these deductions exceeds the $9,500 standard deduction. Student loan deduction: The interest on Angie's and Terry's student loan debt is probably tax-deductible. 401(k) contributions: Uncle Sam helps your retirement planning by excluding your 401(k) deferrals from taxable income.

If Angie and Terry are not familiar with these deductions, then they should consider having future returns prepared by a professional tax preparer, who can often pay for himself (and then some) by finding additional tax deductions. Alternatively, popular tax preparation software packages are easy to use and can help taxpayers find deductions.

As young parents, Angie and Terry have many financial opportunities and obligations, but with a little smart planning, they'll protect their family and be on the road to gradually achieving all of the very important goals they've set for themselves.

Need to get your finances in order? Apply for a makeover.

Guest columnist Greg Schick, CFP is a financial planner at Kochis Fitz, a wealth management firm in San Francisco.