Having a baby is an extraordinary, life-changing event. Although positive emotions can overwhelm new mothers and fathers, parenthood also creates significant responsibility—and sometimes anxiety. Without proper planning, a little bundle of joy can lead to a very large financial burden. There is no way to fully anticipate the emotional, financial and lifestyle shifts of becoming a parent. But here are some key areas that all parents should address with their financial planner:
1. Review Additional Living Expenses and Plan Accordingly
If your financial house is in order, you may already have a strong handle on your monthly cash flows and budget. But everything changes when you have a baby. Evaluating the major additional expenses and understanding how to optimize after-tax savings is imperative for long term financial success.
a. Health Insurance Family Coverage
Health insurance costs are rising. According to Zane Benefits, the cost of family healthcare has tripled since 2001 and continues to grow at an increasing rate, climbing 6.3% in 2015. At the very least, new parents should expect family coverage to cost an additional few hundred dollars per month. But for those with less competitive benefits, health insurance premiums may increase by $500 – $1,000 per month. Working parents should compare family coverage options from each employer. They should also look to a public exchange for potentially more competitive rates. Keep in mind, however, that employer provided insurance is paid pre-tax, where insurance through an exchange is considered a medical expenses and is only deductible to the point it exceeds 10% of the couple's adjusted gross income (AGI). This tax difference could play a significant role in the analysis.
Young parents should also take advantage of Health Savings Accounts. Commonly known as HSAs, these vehicles allow for pre-tax contributions and growth, with zero tax upon distribution as long as funds are used for qualified medical expenses. This can represent a significant tax savings in the event that young families have a high deductible health care plan with substantial out of pocket expenses. Even healthy babies and toddlers require several medical visits for various reasons. At a 25 percent tax rate, using an HSA for $2,000 of eligible medical expenses could mean $500 in savings. Parents should estimate medical costs on an annual basis, and choose the plan with the most cost-effective option.
Childcare, either through an in-home-provider or daycare facility, is very costly. According to a Boston Globe study, the average cost of full-time childcare for an infant in Massachusetts (my home state) is $16,430, or about $1,370 per month. For working parents, this represents the largest additional cost to having a child. But there are some savings opportunities. First, the Dependent Care Tax Credit allows parents to claim up to $3,000 in childcare costs per dependent, up to a maximum $6,000. Depending on household taxable income, this could mean a tax credit of up to $2,100 for two children in Daycare, or $1,050 for one child. There are restrictions and rules for the Dependent Care Credit, and parents should consult a tax professional for advice on their personal situation.
The better savings option may be available through an employer Flexible Spending Account, or FSA. Similar to an HSA, employers allow individuals to fund an account with pre-tax dollars to be used towards childcare of up to $5,000 per employee. In some circumstances, this could provide a better result than the Dependent Care Credit. But the best option depends on the parents’ tax rate, and each situation should be examined with the help of a financial planner and tax advisor.
c. Baby Gear, Food, and Diapers
Next to contact sports, few activities require the amount of equipment needed for the care taking of a young children. Car seats, strollers, high-chairs, swings, cribs, and jumpers are a few of the items young parents will need in the arsenal. Although baby showers can relieve some of the burden, additional purchases are often necessary and can cost upwards of a few hundred dollars each. For the more frugal parents, many of these items can be purchased second hand on Craigslist, EBay, or local Facebook “yard sale” groups at a fraction of the cost. For certain items, this can represent significant savings.
One major consistent budgetary expenditure are the baby’s living expenses. This is including food, diapers and clothing. Parents should minimize these necessary expenses as needed through deal hunting and coupons. Also, to simplify the overwhelming responsibilities of parenthood, automating these necessities through a delivery service like Amazon Prime can reduce the stress of weekly shopping trips and running out of supplies at an inconvenient time. Anyone that takes toddlers to the grocery store can attest to the value and convenience of home delivery!
Overall, the big and small ticket items, even with the help of friends and family, can amount to a significant financial outlay. The value of proactively planning for these items cannot be overstated. If unexpected additional weekly expenditures cut into a rigid budget, the results could be disastrous.
2. Review Life and Accident Insurance Needs
Risk management is a cornerstone of any financial plan. Children need significant financial support, sometimes into adulthood. In the event of a death or accident, and the parent is no longer able to provide, a safety net is necessary for living expenses in the form of life and accident insurance to protect the present value of future income. Although some coverage is available through employee benefits, supplemental insurance through an outside provider is usually necessary.
The most common recommendation for young parents is term insurance because it is inexpensive. Despite being less popular among fee based financial planners, whole life policies may play a role in a sound financial plan depending on an individual’s circumstances. Young parents should speak with their financial planner or insurance professional to review their needs. Regardless, adequate life insurance is a must for any parent.
3. Education Planning
According to the American Action Forum, the cost of college education has outpaced inflation for decades. For many Americans, funding a full college education is an unrealistic expectation. Parents, however, should still save for college. One of the best vehicles for this goal is the 529 College Savings Plan.
529 plans are, essentially, investment accounts. They grow tax free and can be used for qualified higher education costs, as defined by the IRS. These include tuition, room & board. It also includes computers and other technological equipment (if said equipment is required by the course). From a psychological perspective, funding a 529 plan can be a lot like funding a 401(k). They both have regularly scheduled contributions from savings, or in some cases, directly from payroll.
529 accounts can be established to meet education funding goals with lower expenses and minimal risk. Parents should consult their tax advisor or IRS Publication 970 for questions about whether specific expenses are qualified.
529 Plans are inexpensive and easy to establish.
4. Invest for the Future
As your child reaches certain milestones and accomplishments, generous friends and family may send gifts in the form of cash or checks. As years pass, there are birthdays, graduations and other events which may provide young ones with the opportunity to open a bank or investment account. Traditionally, opening a savings account with your children has been a good educational exercise. But depending on the amount of money, it may be a good practice to begin investing some funds for the future. Consider an investment in the form of a Uniform Transfers to Minor Act (UTMA) custodial account.
This allows the parent to open an account on behalf of the child, and act as custodian with full discretion over the account activity. Many times, parents will open a brokerage UTMA Account and choose a diversified portfolio built for long term investment success. All of those first communion funds and birthday funds may seem small at the time. But if consistently invested in a well-diversified portfolio, they can amount to a significant nest egg when the child enters adulthood. An annual investment of five-hundred dollars over eighteen years in a balanced account that achieves an average annual return of 7%, after fees and expenses, could amount to over $18,000 when the child reaches adulthood. That's no small amount of money!
In short, this is one more opportunity to achieve compound interest over the long term.
Parents should be wary of two items with UTMAs. First, parents must report any investment income greater than $2,100 on their own return. This, known as the “kiddie tax” may only have a minimal tax impact. But it could present reporting issues if overlooked. Parents should consult their CPA. Second, by way of law, the account legally transfers to the minor when they reach the age of eighteen to twenty-one (depending on the state). Many parents may not want their teenage children to have unfettered access to funds. This will require some estate planning. For example, the establishment of a trust for the benefit of the minor with the parent serving as trustee. Parents should address these items with an estate planner.
There are many areas of personal finance to consider and revisit throughout the journey of parenthood. While some are mandatory and others may depend on a person’s unique situation, it is important that all parents sit down with their financial planner to establish the best course of action for achieving financial success and peace of mind.
Disclosure: Claro Advisors, LLC (“Claro”) is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). Information contained in this post is for educational purposes only and is not to be considered investment advice. Claro provides individualized advice only after obtaining all necessary background information from a client. Please contact us here with any questions.