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Carrie Schwab Pomerantz Money-Smart Families
Posted on Tuesday, April 10, 2007, 12:00AM
The primary task of parenting (besides loving, of course) is preparing your kids for independence. You teach them about life and give them the tools and the wisdom to make the most of their talents and their opportunities.
It's easy when they're young. "Look both ways before crossing the street." "Study hard." "Do your best." But as your kids get older, the issues get more challenging -- sex, drugs, and alcohol come to mind -- and the conversations get a lot more difficult.
Yet too few parents are having the one conversation that's vitally important to their children's future, and which -- when compared to talks about sex or drugs -- is surprisingly easy to begin: The one about building wealth.
It's Up to You
I'm not talking about motivating your children to get rich. I'm talking about teaching them to take full advantage of one of the most powerful financial opportunities they'll encounter when they enter the working world: company-sponsored retirement plans like 401(k) and 403(b) plans, as well as their close relatives, IRAs.
The fact is that retirement is one of the biggest financial challenges your kids -- or any of us -- will have to face, and the next generation in particular will probably bear much of the burden themselves. But if you can convince your older children to invest early, regularly, and aggressively for their long-term future using tax-advantaged plans, you'll be giving them the chance to build the kind of wealth that could not only ensure a comfortable retirement but also give them an unprecedented degree of flexibility and freedom when they get older.
I realize that few teenagers or even young adults are very focused on retirement planning. But according to a recent survey conducted on the attitudes and expectations of teens toward money, they're positively eager to learn about investing for the future. In fact, 89 percent of the teens surveyed said they want to learn how to make their money grow.
Even more significant, just 20 percent of them said that "my parents/guardians have taught me how to invest money wisely" and only 11 percent said their parents have educated them about the importance of a 401(k) plan. They want to know more, and they're sure not going to learn it in school.
The Importance of Starting Early
Obviously, there's a lot to teach when it comes to investing, from the various investment opportunities (stocks, bonds, mutual funds, exchange-traded funds) to ideas like asset allocation, diversification, and risk tolerance. But as a first step, I urge you to explain to your older kids that they possess an incredibly valuable and incredibly easy-to-use asset: time.
A couple of examples should drive the point home. If your 18-year-old son could invest $1,000 a year in a traditional IRA (in which taxes on investment income are deferred until withdrawal), and earn an average annual return of 8 percent, his retirement account would be worth more than $328,000 (minus investment costs) when he turned 60. That's a pretty dramatic demonstration of the power of compounding growth.
But the outcome is even better for tax-deferred accounts such as 401(k) plans, many of which offer a company "match." Let's say your 22-year-old is about to start her first job, which pays a salary of $30,000 a year. Her company offers a 401(k) plan that enables her to save, pretax, a percentage of her income (the federal ceiling for 2007 is $15,500) and will match up to 5 percent of her savings at the rate of 50 cents on the dollar. She's willing to divert 5 percent of her pretax pay into the 401(k).
The math works like this: 5 percent of $30,000 is $1,500 per year. Her employer match adds another $750 (50 percent of $1,500), so her annual investment totals $2,250. That's a good start made even better by the fact that it only "costs" her $1,225. (Her $1,500 contribution is made pretax; assuming a marginal rate of 15 percent, this reduces her tax burden for the year by $275. So the net cost to her of a $2,250 investment is just $1,225.)
Let's also assume that she earns an average annual return of 8 percent. By the time she's 60, her savings would amount to more than $535,000 (minus investment costs) -- and that's assuming she never increases her contributions at all. If she leaves the company, she can take the money with her by rolling it into her new employer's plan or rolling it over into an IRA; it solely belongs to her.
I hope your children can put away even more of their earned income through these plans. But the point of these examples is crystal-clear: Even a relatively small amount has the potential to turn into a relatively big sum when invested over a long time period. And, in any case, chances are good that these early adopters can increase contributions as they get older and their salary goes up. Finally, some employers are considerably more generous with the company match. The potential of these investment vehicles is enormous.
Hands-on Experience
You can use examples like these (or your own retirement plan experience) to start the discussion of building wealth over the long-term. Lesson No. 1 is the value of starting early. But you should also point out the tax benefits of company-sponsored retirement plans -- the chance to use pretax dollars and to defer taxes on investment income and capital gains.
And, of course, highlight the irresistible allure of the employer match. It's as close as they or anyone else will ever come to an immediate and often substantial return on their investment.
But if you have the opportunity -- say your teenager has a job at the local mall or your college-age kid is working part-time -- urge him to open an IRA now and get his feet wet with some actual hands-on investing experience. Even if the amount invested is small (and even if you have to fund it yourself), it can be an incredibly valuable learning experience.
You can teach him about the importance of asset allocation and managing risk, and the potential rewards of seeing an investment grow. Not only will your child be starting early on a path toward building wealth, he'll be building a foundation of knowledge and a positive habit that will serve him well for a lifetime. After all, for many people, the 401(k) plan or its equivalent in a first job is their first opportunity to invest. Give your kids a head start.
Obviously, if you have grown kids working at jobs with employer-sponsored plans, you should definitely urge them to participate -- and help them take the first steps. Encourage them to get started, even if it's just a percent or two of their salary; most people don't even miss the contributions from their take-home pay once they get going.
If they're really strapped for cash -- for instance, if they have huge student loans or work in a city with a particularly high cost of living -- you might even consider helping further. You could make up the difference from what their take-home pay would be without a 401(k) contribution so that their income stays the same while they're struggling with the beginnings of life on their own. An even better idea is to offer a match of your own to encourage them to save.
Investing More Aggressively
In my hypothetical examples above, I used 8 percent as an average annual return. Part of your discussion about building wealth should focus on the importance of investing for growth. In other words, your kids can benefit from more aggressive exposure to the equity markets.
Some kids are surprisingly risk-averse when it comes to investing, but lower-risk/low-return investments won't give them the growth they need to outpace inflation and accumulate wealth. History shows that three or four decades is plenty of time to weather the normal ups and downs of the equity markets, so I believe you should urge your children to be as growth-oriented as they can, and a strong case can be made for people in their 20s to be substantially invested in a broadly diversified portfolio of U.S. and international stocks.
Of course, these decisions are personal; someone who is completely risk-averse, who would only be able to sleep at night by having the most conservative investments, will typically have to balance that preference by saving more, usually a lot more, to reach the same ultimate goal.
Again, It's Up to You
The daughter of a friend of mine recently got her first "real" job, and she positively pounced on the opportunity to participate in her company-sponsored plan.
When I asked what motivated her, she said that for as long as she could remember, her father had been selling her on the virtues and benefits of 401(k) plans. "It was like a mantra," she told me. "'Participate in your 401(k). Participate in your 401(k).' And it worked!"
It can be hard, sometimes, to imagine a 17-year-old or a 21-year-old actually listening to your advice. But when it comes to the challenge and the opportunity of building wealth, you can have a huge impact on your children's future. So sit them down and have the talk.
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Recent Articles by Carrie Schwab Pomerantz
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Promoting financial fitness is one of Carrie Schwab Pomerantz's passions, particularly when it comes to helping families give their kids the head start they need to thrive as adults. Visit Schwab MoneyWise for additional resources.
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