Planning to retire? It can be to your benefit to help your children learn how to become financially stable. In a previous blog on millennials, we discussed how to broach the subject of basic money literacy. In this article we’ll outline what basics of how they can work toward financial independence.
Spend less than you earn
This step is as important as it is basic. It is nearly impossible to get ahead if you continually spend too much. The following steps could help.
Automatically save to your employer’s retirement account. If you don’t see it you, you won’t spend it. This is a great way to save for retirement.
Make sure your regular fixed expenses leave room for things like eating and filling up the car with gas! Too often we see rent and car payments eat up a budget so that overspending is inevitable. Work with a budget like this sample budget spreadsheet to see how much in rent and car payments you can afford. If needed, pile in with a bunch of roommates.
Unexpected things happen on a regular basis. To avoid the feeling you can’t get ahead, you could set money aside every month for meet expenses that pop up. Set up an automatic transfer from your checking account to savings each month.
Build an emergency fund
Things go wrong. People lose jobs. As financial advisors, we suggest having six months of living expenses in the bank for an emergency fund. This can take quite awhile to build. Start by saving $1,000. Then one month’s worth of expenses and go from there.
Understand the various ways you are taxed
You don’t get to keep all that you earn and even your spending has tax consequences. Below are the various ways you are taxed. Understanding taxation will go a long way in becoming financially savvy.
Sales Tax. You’ve been experiencing this since you were a child. You buy an item and the bill is more than what the item costs. Each state has a different sales tax as well as rules on what items are excluded.
Federal Insurance Contributions Act (FICA) Tax. This 7.65 percent tax comes right off the top of your paycheck. The FICA tax is comprised of 6.2 percent Social Security tax and 1.45 percent Medicare tax.
Ordinary Income Tax. Many states and some cities have income tax. The more you make the more you’re taxed. Learning which types of savings and investments are taxed as ordinary income (the regular paycheck type income tax) and which have a more favorable tax is really important to your financial security in the long run as well as cash flow in the short run. You can view the 2019 federal tax tables here.
Capital Gains Tax. This is a tax that is assessed when you sell an asset that has gained in value. For example, let’s say you bought Apple stock when it cost $100 per share. Let’s say you then sold it at $175 per share; you have $75 of gain, and you will pay capital gains tax (which is less than ordinary income tax) on the gain. Capital gains tax is zero, 15 or 20 percent, depending on your income and filing status.
Transfer Tax. If someone gives you money, that’s a transfer of money. If someone dies and leaves you money, that’s a transfer of money. A transfer of money may or may not come with a tax, which can be called a transfer or estate tax. It generally takes a big gift or inheritance for it to be taxed. You don’t have to worry about this until you give over $15,000 to any one person in a year, or will pass away with several million dollars.
Understand the Miracle of Compound Interest
As Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
You earn money. Hopefully you save and invest some of that money. Compound interest is where your money can earn more money, and the longer your money is invested the more it goes to work for you.
An example is: Two siblings invest $5,500 per year and earn a 7 percent interest rate each year. The first sibling invests for the first 10 years and stops. The second sibling invests starting in the 11th year and keeps investing for 20 years. The third sibling was really motivated and invested $5,500 for all 30 years. Not surprisingly, the child who invested all 30 years has more money than the other two, and due to the “magic” of compounding, as you can see below, the sibling who invested only in the first 10 years has more money than the sibling who invested for 20 years but started later.
|
Sibling One |
Sibling Two |
Sibling Three |
|
|
Years of Investing |
First 10 |
Years 10-30 |
30 Years |
|
Total Invested |
$55,000 |
$110,000 |
$165,000 |
|
Balance in the 30th Year: |
$296,798 |
$226,868 |
$522,273 |
While your tax rate is low, invest in Roth IRA
We just saw how investing for the future can pay off, especially if you start early. A Roth IRA is an investment account where you can put in for example $5,500 and invest it. There is no tax deduction for that contribution. The rules are, you need to leave it in the account at least 5 years and until you are age 59 ½. If you follow the rules, the funds grow tax free and will come out tax free. So if you combine the miracle of compounding with the Roth IRA, you’ve may have hit a home run.
While there is a lot more to learn about financial stability, the above will help your children get a start on understanding money. This in turn, can help your own financial stability when you feel your children can fund their own lifestyle.
Information provided is not intended to be a projection or prediction of current or future performance of any specific product. All financial products have an element of risk and may experience loss. Past performance does not indicate future returns. The data quoted does not guarantee results; estimates of future performance are based on assumptions that may not be realized.