When it comes to kids and money, some parents never learn.
We’re not talking about spoiling your kids rotten or letting them blow money on inane purchases. Instead, we’re talking about the sort of fundamental mistakes that would get you thrown out of a freshman finance class. Here are 10 of the more egregious errors, covering everything from saving for college to buying life insurance for your child:
– Mistake No. 1: Investing your toddler’s college money too conservatively. “That’s the most common mistake that I see,” says Kenneth Klegon, a financial planner in Lansing, Mich. “Parents think this is the college money, so they really should be conservative” and put the bulk of their money in bonds and money market funds. “But if you’ve got enough time, that’s the wrong thing to do,” argues Klegon. Historically, stocks have done better in the long run than bonds, so they should be your best bet for making college money grow.
– Mistake No. 2: Buying EE savings bonds if you are earning a hefty salary–or expect to. If you purchase EE savings bonds and use the proceeds to pay for college, the interest you receive when you redeem the bonds isn’t taxable. But you get the full tax break only if, in the year you redeem the bonds, your income is below certain thresholds.
– Mistake No. 3: Purchasing cash-value life insurance simply to pay for your child’s college education. Term insurance pays a death benefit and nothing more, while cash-value policies combine a death benefit with an investment account. Many insurance agents advocate buying cash-value life insurance, and then tapping the cash buildup to pay for college.
A good strategy? Klegon has his doubts. “Are you buying life insurance because you need protection or because you think it’s a good investment?” he asks. “If you don’t need the protection, it’s not a very efficient way to grow your money. And if you need insurance, pure term will probably be more cost-effective.”
Peter Katt, a fee-only life-insurance adviser in Mattawan, Mich., agrees that it’s difficult to justify buying cash-value life insurance simply to fund your child’s college education. But he says that if you are buying a cash-value policy to protect your family in case of your death, the policy can also provide a good way to amass at least some college money. He says you should buy low-load universal life insurance or low-load variable life insurance and “superfund” the policy–paying more than is required to keep the policy in force–with the aim of building up the cash value quickly.
– Mistake No. 4: Saving money in your child’s name when you hope to get financial aid. Sure, it’s tempting to do so, because you get a small tax break. If your child is under 14, the first $650 of investment earnings is tax-free and the next $650 is taxed at 15 percent. Above $1,300, gains are taxed at the parents’ rate. Once your child turns 14, all investment earnings are taxed at the child’s own rate, usually 15 percent.
But while most tax breaks are irresistible, this one could come back to haunt you. Under the federal financial aid formula, kids are expected to put 35 percent of their savings toward college each year, which means that money in their name counts heavily against them when applying for aid. Parents, meanwhile, are expected to pony up a maximum of only 5.65 percent of their assets.
– Mistake No. 5: Putting lots of money in your child’s name, even if you don’t expect financial aid. When you invest in your child’s name, you usually open a custodial account under your state’s Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. With these accounts, children get control of the money when they reach the age of majority, usually 18 or 21, depending on your state. At that point, they are free to blow the money on anything their little hearts desire. A Harvard education may not make your child’s shopping list. Because of this risk, you shouldn’t put too much money in your child’s name.
– Mistake No. 6: Waiting until your child applies to college before thinking about financial aid. Kalman A. Chany, president of Campus Consultants, a New York-based firm that counsels families on financial aid, says you should start thinking about aid eligibility when your child is in 9th or 10th grade. When doling out aid, some colleges now want two years of tax returns, which means they will be looking at your earnings going back to January of the year that your child was in 10th grade.
To have the best shot at getting a decent amount of financial aid, you need to minimize your income during these years, as well as the years that your child is in college. Chany says you should make a particular effort to keep down your income in the calendar year before the year that your child enters college. Your child’s first year of financial aid is based largely or entirely on this year, and this year then influences aid decisions in subsequent years.
Chany suggests that, in an effort to hold down your income, you should avoid retirement-account withdrawals, delay cashing in savings bonds and hold off selling stocks with large capital gains. He says large charitable contributions can also hurt your child’s aid eligibility. How come? Charitable gifts, if deducted, lower your taxes, which makes it look like you have more income available to pay tuition.
– Mistake No. 7: Letting your children earn and save too much when they are on financial aid. This is possibly the most perverse aspect of the financial aid system. “After students make about $2,000, every additional dollar they earn and save will cost them 85 cents in aid,” Chany says.
How can that be? After roughly the first $2,000 in income, every additional dollar earned results in 50 cents in lost aid under the federal financial aid formula. If these additional dollars are then saved in the child’s name, they cause an additional 35 cents in aid to be lost under the formula.
– Mistake No. 8: Pulling money out of retirement accounts to pay for college. If you tap your retirement accounts to pay for college, you will get hit with a quadruple whammy. First, you will owe income taxes on the money withdrawn. Second, you will have to pay a 10 percent tax penalty on the money if you are under age 59 1/2. Third, the money withdrawn from your retirement account will boost your income, thus hurting your child’s financial aid eligibility. Finally–and maybe most critically–you could seriously dent your own ability to retire.
So what should you do? Consider borrowing while your kids are in college and then paying back the money after they graduate. By then, you may even be able to tap your retirement accounts without incurring the 10 percent tax penalty.
