From your first dollar of allowance to your last paycheck, money makes up an important part of every person's life. In today's column, I'm going to lay out essential money lessons that everyone should learn over the course of that lifetime -- in roughly chronological order.
- Early Childhood: The basics of money management
- Young Adult: Preparing for college
- Working Adult: Preparing for major life events
- Working Adult: Planning for retirement
- Retired Adult: Maximizing retirement
Early Childhood: The basics of money management
Bestselling author and church minister Robert Fulghum famously wrote that everything he ever really needed to know, he "learned in kindergarten." And for most people, that's where the building blocks of good money management begin -- in school, and particularly, in math class.
Reading (10-K filings with the SEC for example), writing (constructing a "buy thesis" for a stock), and arithmetic are all fundamental to good money management -- but math especially. Encourage your kids to learn their "times tables" by heart, and to practice adding and subtracting figures in their heads, and they'll have a leg up on the competition for decades to come.
What role does math play in money management? The better question is what role it doesn't play?!
Balancing a checkbook, or more likely these days, double-checking the math in your online banking statement, requires subtraction and addition. Calculating the compound interest on a credit card debt or a mortgage can't be done without multiplication. And any time you figure the price-to-earnings ratio on a stock -- that's division.
Sure, all of these are elementary mathematical concepts -- no calculus required. But they're all absolutely essential skills to learn for good money management.
Early childhood is also a great time to start teaching children the practical aspects of money management. Many parents, for example, will pay their young children a weekly "allowance" -- a set allotment of money paid regularly, sometimes in return for doing chores, and other times paid independently of whether chores get done. Regardless of whether an allowance is paid in consideration for work, introducing children to the concept of a regular income stream, which must be managed "paycheck to paycheck," is good training for the workday world.
And of course, with money in hand, children can also be introduced to the concept of banking -- and how it generates interest income on savings. Believe it or not, some banks still offer passbook savings accounts -- the kind where you record your deposits, withdrawals, and interest in a small booklet. Or, if your child has access to a computer, she might prefer to jump directly into the 21st century with an online banking account. At most banks, a parent can open a savings account, tied to the parent's own bank accounts to as to avoid maintenance fees associated with having a too-small bank balance.
And if you choose to have your bank statements mailed to you, your kid will probably also get a kick out of receiving a letter in the mailbox every month.
Young Adult: Preparing for college
As you progress from kindergarten to elementary school, then to middle, junior high, and high school, all along the way, the prospect of going to college -- and having to pay for it -- looms large.
Kids today can expect to pay nearly $21,000 a year on average to attend a four-year public university, and it can cost more than $35,000 a year to go to a private college. Multiply by four years of education (there are those math skills at work again), and you see how the average college education in America today can easily set a family back more than $100,000 per child.
So how does an ordinary kid from a wage-earning family raise that kind of cash? How should a young adult think about preparing her finances for college? Well hopefully, your parents have already started the process off for you by setting up a 529 savings plan for college, and perhaps a Coverdell Education Savings account as well. The former are generally state-sponsored plans that permit you to deposit pre-tax income that can grow tax-free until needed for college. The latter is a more limited savings vessel, not tax-deductible, and limited to $2,000 in contributions per year.
To get a complete view of what funds you have available to pay for college, though, you really want to start with FAFSA, the Free Application for Federal Student Aid. If you want to have any chance of getting a grant or a loan out of any college you attend, you're eventually going to have to hand your college a FAFSA form, so it is important to get familiar with it sooner rather than later.
In the course of filling out the form, you should get a good idea of what assets you bring to the paying-for-college table -- how much savings you have, and what your parents' and your own incomes are, for example. Then, you can compare this to the cost of the colleges you hope to enroll in, and get a better idea of how much financial assistance you might need to secure in order to attend.
Once you know which colleges you can attend, though, it's time to give some thought to which colleges you should attend -- based on price. In The Financial Aid Handbook, former university administrators Carol Stack and Ruth Vedvik argue forcefully against any student taking on more than $32,000 in total debt to fund a college education. To understand why, they describe the case of a student (Cortney M.) who took out much more -- $100,000 -- in student loans to pay for a bachelor's degree from New York University.
Paying off that debt, explain Stack and Vedvik, requires Cortney to earmark $700 every month for student loan payments -- about as much as a mortgage payment on a starter home. At $8,400 a year, loan payments consume nearly 20% of her $45,000 a year salary. Assume subsistence level annual living expenses of $24,000 for food and rent, add the cost of health insurance, and Cortney ends up with almost nothing left over at the end of the year. Essentially all of (or what could have been) her disposable income instead goes to pay student loans.
And let's not forget that even this bleak scenario depends on Cortney landing a job that pays $45,000 after college. Because of her debt obligations, Cortney cannot even afford to consider taking a job paying anything less, and this closes the door to any number of lower paying -- but perhaps more satisfying -- jobs she might have wanted to take. For example, working in government, for a non-profit work, teaching, or other positions where job satisfaction might trump fat paychecks.
Because of her debt, Cortney has limited ability to save money to eventually buy a home, build up a college fund for the kids, or save for retirement. All of this because she took on $100,000 worth of "good debt."
All of which is a strong argument against attending a pricey school, even if you can secure loans sufficient to pay for it.
Working Adult: Preparing for major life events
Now let's take a closer look at financial decisions you'll encounter after graduating from college.
We'll begin with budgeting.
You probably got your first exposure to living on a budget in college. That's where many young Americans first experience having to balance income against expenses on their own, without assistance from parental units. Even if your parents (or the federal government, or a friendly financial aid officer) took care of the major costs of tuition, room, and board, you probably had to cover at least the incidental expenses of maintaining a college lifestyle -- ordering pizza and dining out at bars and restaurants, buying the occasional sweatshirt at the college bookstore, and "feeding the meter" on the washers and dryers at the dorm.
Now that you've graduated from college, you're truly on your own at last and need to cover the full freight of living on your own, sans safety net. Very soon you'll realize that if your expenses exceed your income, you're cruising for a financial bruising. So how do you avoid that? By establishing a budget.
(Yes, it's time to put those elementary mathematics skills to work again!)
First, take any savings you've amassed over the past year and divide by twelve to stretch those savings over the course of the next year. Add to that any income you expect to receive each month from your job.
This is how much you can theoretically afford to spend in a month.
Next, make a list of your likely expenses over the course of a month. How much is your rent? Are utilities included? What do you expect to spend on food? On entertainment? On health insurance? Did you ignore our advice in the preceding section and take on burdensome student loan debt?
Begin subtracting these expenses from your expected income, but once you notice your likely expenses approaching your total available funds, you're entering the danger zone. Stop. Go back over your expenses, and start looking for things to cut. (A couple hints to get you started: You probably need internet access in the 21st century, but cable TV is a want, not a need. And cellphones? "Unlimited data" is nice, but $100 a year can get you pre-paid cellphone service if you save your internet surfing for when Wi-Fi is nearby).
Ideally, when you're done adding, subtracting, and subtracting some more, you'll end up with a budget in which your income exceeds your expenses by some appreciable margin. Let's say 10% to start.
Now, take that 10% and set it aside in an emergency fund. As you proceed through the year, this emergency fund will form the "cash cushion" you can fall back on. If you miscalculated your expenses, that 10% cushion should give you a margin of safety that might -- if you're lucky -- prevent you from going over budget despite your mistake, and give you time to recalculate before you actually go into the red. Or you may suffer a significant unexpected expense such as a car repair, job loss, or medical emergency. In that case, you might need to tap the accumulated savings from your emergency fund to cover the bill.
How long do you need to keep saving until your emergency fund is "big enough?" As a general rule, we advise setting aside three to six months' living expenses. The reason being, you want your emergency fund to be sufficient to ensure that, in the event of a long illness or period of unemployment, you won't be tempted to raid other savings, intended for other purposes, that you'll be setting up.
What other savings "buckets" should you be thinking of creating, in addition to the emergency fund? Here are just a few ideas to begin mulling:
- Buying a house. Unless you're a fan of apartment living, you need to begin planning years in advance of making a real estate purchase. As a general rule, mortgage bankers want to see you put up 20% of the purchase cost of a house as a down payment before loaning you the rest. So for a $250,000 house, for example, that's $50,000 you need to amass.
- Buying a car. This isn't as big an expense as buying a house, but if you plan to finance a car purchase, you still may need to pay a few thousand dollars up-front. Alternatives to buying while you save up the cash include leasing a car, using public transportation (if it's available in your area), walking, bicycling, or Uber.
- Weddings. Traditionally, the bride's parents pay for a wedding while the groom's parents pay for the honeymoon -- that's the way it's supposed to work at least. But with the cost of your average wedding recently tipping the scales at $32,000-plus, if you want a ceremony with all the bells and whistles, you may want to start budgeting to cover at least part of the cost on your own.
- College. Remember how we mentioned the 529 plans and Coverdell Savings Accounts your parents may have used to help pay for your college? If you plan on having kids, you should probably plan on funding these kinds of savings vessels for them, as well.
Retirement ... Actually we need to talk some more about debt.
We've talked a lot about spending so far, but we've only talked at length about one form of debt really -- student loan debt. Problem is, with all the spending going on up above, there's a good chance that at some point in your adult life, you're going to find you've overspent, and ended up in the red on your personal financial balance sheet.
Don't be alarmed. This is not uncommon. Still, it's an issue that needs to be addressed, because until your debt problems are dealt with, it's difficult to focus on saving for retirement.
According to financial site NerdWallet, Americans as a whole have amassed nearly $1 trillion in personal financial debt. The average household owes nearly $16,000 on its credit cards, and more than $133,000 in total debt, including student loans, mortgages, car loans, and so on.
Worse, that debt is growing.
You've probably heard the old Albert Einstein quote that "compound interest is the most powerful force in the universe," right? And yet, compound interest is really nothing more than elementary math: $100 invested at 5% interest becomes $105 in one year, $110.25 in two years, $115.76 in three years, and ... $898.50 over the course of a 45-year life at work. Graduate from college at age 22, immediately invest your $100 graduation gift from Great Aunt Betty in a CD paying 5% interest, and by the time you're ready to retire at age 67, your money will have grown nine-fold.
Pretty great, huh? But here's the thing: Compound interest is a double-edged sword. Interest paid to you can turn a small sum into a large fortune over time. But interest that you pay to a bank -- on, say, a credit card balance or payday loan -- can grow even faster.
Your average credit card these days is charging 16.9% annual interest, according to data from Bankrate.com. $100 charged on a card today, if allowed to roll over and over and grow bigger and bigger, would turn into $898.50 worth of debt, not in 45 years, but less than 15. Allowed to build up along the same 45-year yardstick I mentioned above, that same $100 would turn into a debt of truly gargantuan proportions -- $112,629.72.
Granted, in practice, most credit card companies try to mitigate such doomsday scenarios (and get their money back faster) by requiring that you make minimum payments to pay down your debt sooner. The flipside of that, though, is that if you miss a payment or even are just a few days late, penalty fees could cause your debt load to increase even more.
Now, experts reassure us that not all debt is bad. Some even argue that student loans taken out to pay for college, car loans that facilitate taking a high-paying job that's farther away than walking distance, and mortgage loans that allow you to build home equity and claim a home mortgage interest deduction on your taxes are examples of "good debt" that, when used responsibly, is worth taking on.
But the fact remains, whether you're talking about "good debt" or "bad debt," all debt must eventually be repaid (unless the prospect of bankruptcy court appeals to you). And until it has been repaid, all debt is a burden that will crimp your lifestyle and add stress to your life.
So how do you deal with debt?
Do you remember how we were saving 10% of our income up above, and putting it toward an emergency fund? Remember how we decided that the emergency fund would be "big enough" once it was equal to about six months' worth of income? Did you wonder what we'd be doing with that 10% once the emergency fund was "done?" Well, here's the answer: We're going to use it to pay down debt via a "debt snowball" plan.
The concept is pretty simple. We're going to pay off our debts, one by one, until they have all vanished. To start, pick a credit card (any credit card) and use the 10% of your income that used to go to your emergency fund, to gradually pay off that credit card. Once you're done, not only will you have paid off that credit card debt, but you'll also have released yourself from the interest obligations tied to that debt -- giving you even more money to pay off a second credit card (or college loan, car loan, mortgage, and so on).
Lather, rinse, and repeat until all the debts are gone.
(By the way, you may wonder why we pay off debts after establishing the emergency fund and not before it. The reason is that if you drain your cash reserves to pay off your debts, then are faced with an unexpected emergency requiring you to raise cash, you're going to go right back into debt again scrambling to raise cash -- and undo any progress you've managed so far in the direction of debt reduction. This is a "stitch in time, saves nine" situation, where you want to do first things first, and lay a firm foundation for reaching your ultimate objective).
And that ultimate objective is ...
Working Adult: Planning for retirement
Most Americans look forward to the day when they'll have the option of retiring.
There's just one problem: With today's retirees taking out far more from Social Security than they ever put into it, Social Security is due to begin paying out more money in benefits than it takes in from contributions less than five years from now. As things currently stand, the likelihood that Social Security will provide you a secure retirement gets dimmer every day. That means that, if you want to live comfortably in retirement -- or even ever retire at all -- you need to start saving for retirement as soon as possible, and take advantage of every chance to maximize your savings.
This includes maxing out your 401(k) contributions, claiming any matching funds your employer might offer, and -- this is key -- not raiding your own retirement plan by early withdrawals from 401(k) savings. Every time you do that, not only do you undo years of effort you've made in building up your retirement savings. You actually do more damage because the government not only taxes the money you take out, but penalizes you with fees for every early withdrawal you make.
In short: Don't do it.
How much do you ultimately need to save for retirement? Opinions differ, and even underlying assumptions can vary considerably. Your personal retirement number will depend on an interrelation of (a) whether you want to replace 100% of your retirement income in retirement; (b) how much of your retirement nest egg you believe it's safe to withdraw each year to provide that income; (c) how the stock market performs during the years you're retired, and multiple other factors.
No matter how good your command of elementary mathematics, therefore, it's difficult to give a hard and fast answer: "You need to save $X." While some advisors might pull a number out of a hat, and say "you need to save $1 million," (or $1.5 million, or $2 million), the truth is that it's safer to say simply: the more you can save, the better off you'll be.
It's probably more practical, therefore, to focus on how you save for retirement. We've already discussed the steps you need to take before saving for retirement -- establishing an emergency fund and getting your savings for pre-retirement goals such as buying a house or paying for the kids' college squared away. Now it's time to focus on you.
There are plenty of retirement vehicles to choose from when planning for your retirement. 401(k) plans and individual retirement accounts (IRAs) are probably the most popular, though, so let's focus on them. Both 401(k)s and IRAs allow you to put a (limited) amount of money into a fund designated for use in retirement. The major difference is that an IRA is tied to the individual, while a 401(k) plan is tied to a specific employer (even if that employer is yourself, in the case of an individual 401(k) plan). If you change jobs, you may be allowed to leave your 401(k) under the management of your old employer, but you won't be able to make any new contributions to that employer's 401(k).
Most employees faced with this situation will choose to "roll over" the funds in their old 401(k) into an IRA.
Speaking of which, your contribution limits will generally be lower when contributing to an IRA, and higher when contributing to a 401(k). (And yes, you can contribute to both). 401(k)s can also be supplemented with contributions from the employer itself -- again, even if that employer is yourself in the case of an individual 401(k). While the numbers can change every year, as of this writing the most you'll be able to contribute to an IRA is $6,500 (and that, only if you're over age 50 and making $1,000 "catch-up" contributions). For a 401(k), it's conceivable you could contribute as much as $61,000 if you (a) max out your own contributions, (b) are over age 50 and utilize the $6,000 catch-up provision and (c) work for a very generous employer.
Needless to say, if that's an option for you -- take it.
Retired Adult: Maximizing retirement
Free at last, free at last, you've reached retirement. So ... what do you do now? For all the stresses of work, one of the advantages of planning for retirement while you're working was that you had a clearly defined goal: Start saving as early as possible, and save as much as possible, before you retire.
Now that you have retired, the goal gets a bit more open-ended. How do you take what you've made, and put it away, and make the most of it?
The first step is to stretch out your nest egg as far as it can possibly go. According to the National Center for Health Statistics, Americans today can expect to live about 80 years on average -- 76.1 years for men, 81.1 years for women. If you retire at 67 therefore, chances are you'll need to make your nest egg last roughly 10 years -- maybe more (and maybe much more if you defy the averages).
Experts will tell you that the key to making this happen is to adhere to the 4% rule: Take your retirement nest egg, multiply it by 4% (it may be simpler to think of this as dividing by 25), and that's how much money you can take out of your retirement savings to pay for living expenses each year. If you've saved up $1 million for retirement, for example, you can probably safely withdraw $40,000 a year in retirement. That, plus whatever you can get out of Social Security, plus using Medicare to take care of most of your medical expenses, should suffice to get you across the finish line.
Stick to this rule, and experts say your nest egg should last you 30 years -- giving a nice cushion in case you live longer than 10-15 years in retirement.
As for how you spend those years, that's finally up to you: Travel, do charity work, visit with grandkids -- go wild! But there are still a few final details that you should try to take care of when time permits.
For example, do you have a will drawn up? If you're already married, and/or have kids (or even grandkids), you probably should already have one of these in place -- but if you don't there's no time like the present. Sample wills are readily available for download on the internet, but many trusts & estates lawyers will offer a free consultation to discuss the subject.
Feel free to take them up on their offers -- and while you're at it, consult multiple attorneys to get a feel for whether they're all saying the same thing, or whether some may cover more bases than others. During these sit-downs, you might also discuss the advisability of setting up powers of attorney granting someone you trust the right to make decisions on your behalf in the event you become mentally or physically incapacitated. Perhaps consider even a living will instructing your doctors how you expect them to act in the event things get really bad, and you can only be kept breathing on life support. It's not something anyone wants to think about -- but that's what these kinds of lawyers are paid for: To think about the unthinkable.
Trying to think of literally everything a person might need to know about money is a tall order -- and probably doomed to failure because there's always going to be at least one more thing to add. I'll admit, I've given a lot of thought about where to wrap this up, and I can think of only one logical place to stop.
Like a wise man once said, in this life, there are only two things certain: One of them is taxes. The other is death. Financially speaking, death is really your last chance in this life to make a poor financial decision -- this time, one that will burden your family. Parting.com estimates that the average American funeral costs a family up to $10,000. But nearly half that cost is completely elective, like paying too much for a casket that no one will see for more than a few hours, and a headstone that might be visited only a few times a year, if that.
Do you really want your final act on Earth to be paying twice as much as you need to for a funeral? Consider practical alternatives and make sure your final act of fiscal rectitude is responsibly well-done.