How to Help Grandkids Stay Solvent

In last month’s visit we discussed how to educate children and grandchildren to start them on the road toward financial independence. This month, let’s discuss how to help youngsters who already are in the working world and perhaps have started to dig themselves into that financial hole of high debt in which so many people find themselves.

Too many youngsters simply do not know how to handle the income they earn. They also have more access to credit than any prior generation. They do not know how to manage credit by using it selectively and paying debts in the right order. Here are some tips you can impart to them.

Save first. Anyone with income first should set aside long-term savings, often called paying yourself first. The traditional advice is to save at least 10% of one’s gross income. But if a person starts early and invests wisely, a nice retirement fund can be accumulated by saving a lower percentage, if the saving is done regularly.

People just out of school find it difficult to worry about retirement. An effective strategy is to tell them to put minimal amounts in 401(k)s and other retirement accounts at that point. Instead, get them to focus on accumulating the down payment for a home. Have them set a goal of purchasing a home by a certain age, estimate the minimum down payment they will need, and set a plan to accumulate that amount. After they have seen that plan work, once the home is purchased it will be easier for them to save more for retirement after the home is purchased.

Set spending priorities. After savings are set aside, young people need to learn to live within their incomes. Too often, no one ever sat down with them and worked through the numbers to show how to keep expenses from exceeding income through planning. Because they do not plan much, young people often are hurt the most by those irregular expenses that are not incurred monthly: tax bills, auto insurance, emergencies, repairs, and replacements. They need to be shown how to reserve a part of their income each month for these irregular expenses. Impulse expenses also are something younger people need to limit.

Take advantage of employer matches. If an employer matches 401(k) deferrals, those matches are free money. Since young people are not long-term oriented, they view the process as giving up part of their income. They won’t have access to either their deferrals or the employer’s matching contributions for years, so many of them have difficulty seeing this as a benefit or something they have received. The value of the deferrals and matching contributions needs to be demonstrated.

Leave retirement accounts alone. The statistics on the number of people who tap retirement accounts early is staggering. Retirement accounts are especially vulnerable when young people switch jobs. At that point, they have to decide what to do with their 401(k) balances. The correct choice is to roll the account over to either the new employer’s plan or to an IRA. Many of them, however, simply take the cash and pay the income taxes and early distribution penalty. They are happy to spend the 40% to 60% they have left.

Borrowing 401(k) money also is another frequently-made mistake. Many people use the rationale that they are re-paying the money to themselves. But the interest rate charged on 401(k) loans usually is low. If the account would be invested very conservatively, the balance might accumulate to the same amount over time. But the loan takes away the opportunity to invest the 401(k) in higher-returning vehicles.

In addition, the 401(k) borrower effectively pays taxes twice on the same interest. Since 401(k) loan interest payments usually are not deductible, the payments are made with income that already has been taxed. Then, income taxes are due again when the money is distributed whether during retirement or earlier. Over the long-term, a 401(k) loan can be an expensive way to borrow.

Know which debts to pay. Credit is easy for young people to get these days, and they can become buried in debt quickly. Once a youngster has incurred debt, he or she needs to know which debt to pay first.

The interest rate on the debt is the key factor. The higher the interest rate, the more important it is to pay the balance and stop the interest from compounding. Credit card interest rates are so high that it makes sense to suspend saving and retirement programs in order to pay the debt. For debts with interest rates in the single digits, fast payment is not as urgent. A plan of steady payments that also allows the accumulation of savings is workable and shows the young person the value of long-term savings.

As more income becomes available to either invest or pay debt, the young person should be shown the trade off between investing for the future (especially in tax-advantaged investments) and paying debt. The comparison between the potential after-tax return on the investments and the after-tax interest on the debt is the key factor in determining the best use of the cash. Paying a debt is the equivalent of investing to earn the after-tax interest rate that would have been paid on that debt.

Savings and debt often are vague concepts to young people, because no one gave them tangible examples of how to make saving and spending decisions and the consequences of the different decisions. What most people need is a framework for making the decisions they face and a plan for achieving long-term goals.