My good friend Al, who I mentioned earlier this week, recently became a dad for the first time at age 41.
He’s brave to get started at that age. I thought I was a little on the old side when my son was born, and I was only 32. Those sleepless nights hit you a lot harder the older you get.
But I digress.
In honor of Al’s newborn daughter, I’m going to answer some common financial questions for parents or grandparents of young children. If you’re the responsible sort who likes to plan. This one is for you.
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Should I Save for College in a 529 Plan or Something Similar?
The short answer is “yes.”
The longer answer is a bit more nuanced.
If you have excess cash on hand, then, by all means, open a 529 college savings plan, particularly if the kid is young. 529 plans are similar to a Roth IRA or 401(k) plan in that there is no immediate tax break for the contribution, but all capital gains, dividends, and interest grow tax free and enjoy tax-free withdrawals — as long as they withdrawals are used for qualified educational expenses. The younger the kid, the more that tax-free compounding matters.
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If the kid is already a teenager and starts college in a couple of years, there’s not a lot of value in stuffing the cash into a 529 plan, as you’re just going to be taking it out again in short order.
But let’s say you’re starting early. Even then, I’d argue that investing in a 529 plan only makes sense if you’re already maxing out your 401(k) or any other retirement plan.
Your 401(k) plan gives you an immediate tax break, giving you more cash today to invest and compound. If you save diligently early, you won’t need to save as aggressively later in life because time was on your side.
I wrote about this in 2018, revisiting Richard Russell’s classic piece “Rich Man, Poor Man.”
Russell showed that a young worker who invested $2,000 per year in his IRA starting at age 19 and stopping at age 25 would end up with a larger portfolio in retirement than a worker that started investing $2,000 per year at age 26 and continues to do so until age 65. If you don’t believe me, check the math.
By the time your kids are in college, you’ll presumably be at the peak of your career, earning more money than you were when they were born. You’ll be in a better position to help them out of current cash flows. They would also presumably have access to student loans, which you could help them pay back if you wanted.
Under current tax rules, you can also take penalty-free distributions from an IRA or Roth IRA to pay for educational expenses, though not from 401(k) plans. I don’t necessarily recommend you do that, but it’s an option if you need it.
So, again, you should absolutely contribute to a 529 college savings plan if you have the cash flows to do it. But this only makes sense if you’re already maxing out your 401(k) plan.
Should I Buy a Bigger House for the Baby?
As a general rule, people buy more house than they need. It’s nice to have space, particularly when the kids get older. It lets them have their space to crank their music, play video games, and generally be a nuisance on the other side of the house, giving you a little peace and quiet.
Once you have kids, you’re also more likely to have family coming over to visit, and it’s nice to have an extra room or two to put them in.
But a larger home is a bad investment.
To start, it generally means a larger mortgage and a larger monthly payment. It means higher property taxes and insurance costs. It means higher utility bills, as you have more space to keep air-conditioned, and more ongoing maintenance expenses like landscaping and housekeeping.
Also, in my experience, nature hates a vacuum.
If you have more space, you’ll feel pressured to fill it up with new furniture, appliances, larger TVs, artwork, etc. All of that costs money.
I’d love a bigger house, and if my budget allows for it I’d like to upgrade sometime in the next year or two. But up until now, I’ve intentionally kept my housing costs low relative to my income. That’s given me more cash to invest and to spend on things I really enjoy like travel.
It’s better to live modestly and have extra cash to play with than buy a house you can just barely afford and sweat about your finances every month.
In Tokyo, the average family lives in an 800-square-foot apartment. I couldn’t live like that. But I don’t need a 4,000-square-foot McMansion either. And neither do you.
Do I Need Life Insurance?
I’d argue most new parents need at least a little life insurance.
In my family, I have a lot more than my wife does because that’s how the numbers worked out. If I were to croak tomorrow, she couldn’t realistically replace my income. So, I have enough life insurance to at least get the kids through high school and college were something to happen to me.
If something were to happen to my wife, we wouldn’t have a salary to replace. But I’d have to hire someone to take care of all of the domestic responsibilities she handles. At a bare minimum, I’d need a nanny during the workweek.
One of my good friends makes an above-average income, but so does his wife. Either of them could continue to live their current lifestyle indefinitely were the other one to drop dead. They’re exceptionally conservative and live well below their means. I’d argue life insurance would be a waste of money for them.
In your case, spend a little time figuring out what exactly it is you need to insure. You might like the idea of leaving your widow and children with millions of dollars to play with, but that’s not free. The premiums on a policy like that are punishingly expensive. Over-insuring can be nearly as bad for your financial health as underinsuring.
So, make sure you get an amount of life insurance that protects you against the unknown, but not so much as to bleed you dry paying the premiums.