We’d all like to think we’re doing an amazing job setting our kids up for success. We teach them how to read and write, share, take on responsibilities and work hard. But do you spend as much time teaching your kids about money and financial literacy?
You can break your back saving thousands of dollars for your child’s college — but you’ve also got to show your kids first-hand how to manage that money responsibly. After all, without a bit of financial literacy and know-how, what’s to stop your kids from tossing away everything you’ve been building for their future?
But don’t panic. There are plenty of simple ways you can teach kids financial literacy and show them what it means to take on financial responsibility.
This article will explain why financial literacy is important, what it can do for your kids, and how you can start investing now in tools like 529s plans to ensure their assets grow alongside them to safeguard and enrich their futures.
Why is Financial Literacy Important?
Financial literacy is a term that gets thrown around a lot. But what exactly does it mean?
Simply put, financial literacy incorporates all the knowledge and skills that your kids are going to need to make important financial decisions. It includes everything from understanding how a checking account works, what using a credit card means, how to balance a budget, how to use an IRA, set up a pension fund, invest in the stock market and more.
So that’s what financial literacy is. But why is it important?
Financial literacy is critical because it impacts literally every money-related decision your kids will ever have to make. Budgeting, saving, and good money management are absolute essentials if you want your young person to be able to afford to pay for college, buy a home, set up a pension, start a business, save for retirement or anything in between.
Unfortunately, research suggests that most of us haven’t got good money management and financial skills, to begin with.
According to the Financial Industry Regulatory Authority (FINRA), 19% of Americans say they’re regularly spending more than their household income. To make matters worse, 46% of us haven’t even got a rainy day fund — enough to cover expenses for three months in case of emergencies. People who overspend and haven’t got savings to fall back on can often land in hot water if trouble strikes.
Do yourself a favor, and don’t let your kid be one of these statistics. Things don’t always go according to plan. That’s why you need to make sure your kids learn to have the financial means as well as the financial know-how to weather any storm or chase their dreams — particularly where a college education is concerned.
What are the Basics of Financial Literacy?
Financial literacy is an incredibly broad topic. As a parent, it can be pretty daunting trying to figure out where to start.
And while there’d be quite a lot of ground to cover if you wanted to turn your kid into the next Adam Smith (which is the guy economists refer to as “Father of economics”), there are several fundamental basics to financial literacy that you should try to pass onto the kids in your life.
Those financial basics include:
- How to budget
- How to save
- Understanding how interest works
Teaching kids how to budget
Let’s face it: budgeting can be pretty tricky.
Budgeting focuses on the fundamentals of tracking your expenses and income and ensuring they balance to give you the lifestyle you want. If you’re not able to pay your bills on time, chances are you’re not going to be able to save money, either.
By learning how to budget, your kids will be able to see first-hand that money doesn’t grow on trees. You’ve got to figure out how to make tough decisions about what is and isn’t essential, where you want to spend, and how you can invest money for the future.
Teaching kids how to save
If budgeting seems hard, sometimes saving money feels downright impossible. And according to researchers at FINRA, for many Americans, it is pretty much impossible.
Without savings, you’ve got no cash to turn to if you lose their job, want to buy a new house, or help your kids pay for college.
Don’t let this happen to you or your kids.
Saving is a critical aspect of budgeting. That lesson can start with a kid and their piggy bank, but it has major real-life implications. By living within your means and then saving a portion of your remaining disposable income, you’ll be able to earmark funds you can use if emergency strikes (or to help your kids achieve a financial goal).
Teaching kids about interest rates
Interest rates are absolutely critical when we’re talking about finance. Interest is essentially the fee that you pay a lender in exchange for the privilege of getting to borrow their money — and there’s such a thing as a good rate and a bad rate.
One recent survey found that 52% of Americans don’t understand basics like deferred interest rates. Likewise, researchers at FINRA have found that 35% of Americans say they pay the minimum amount on their credit cards — allowing the interest to pile on hard and fast.
Why is it important to teach the young person in your life about interest?
Because interest is the cost of borrowing money, and we all want to keep costs down, right? After all, the higher your interest rate, the more money you’re going to lose out on. This applies to everything from credit cards to a college student loan.
Kids need to understand what interest is, how it works, and how to know the difference between a sustainable and responsible interest rate and a payday loan trap.
What Tools Can You Use to Teach Your Kids Financial Literacy?
One of the best ways you can teach your kids about financial literacy is by showing them how money management and financial responsibilities work in practice.
That means encouraging them to budget while teaching them about saving and interest rates first-hand using a number of investment vehicles designed to fund their future education.
The tools that you decide to use in order to make those money management lessons stick and save for your child’s college just depend on your financial goals and the type of flexibility you want for your child.
But to help you sift through those options, let’s quickly break down three of the most common tools that parents and relatives use to both save for their children’s education and teach their kids about money:
- 529 plans
- Coverdell Education Savings Accounts (ESAs)
- Roth IRAs
Most of us want our kids to go to college — but the sad truth is that college doesn’t come cheap. For the 2020-21 academic year, 4-year private nonprofit colleges were averaging $37,650 per year for tuition and fees alone. Public universities came in at an average of $27,020 a year if your kid wanted to go out-of-state.
That means unless you’re bathing in cash, you need to start saving for your child’s future right now — and 529 plans are a great way to do it.
A 529 plan is one of the most popular college savings plans out there because it offers a wide range of tax and financial aid benefits. In some cases, 529 plans can even be used to save and invest for K-12 tuition. There are two types of 529 plans you should be aware of:
- College savings plans
- Prepaid tuition plans
A college savings plan lets you invest after-tax contributions in mutual funds or similar investments. The overall value of your account may then go up or down based on how those investments perform.
You’ve then got prepaid tuition plans. These allow parents or other relatives to prepay for their kid’s college education by purchasing college credits or units in advance. You can also pay for future tuition at a particular college, and you can make these payments through a number of lump sums or regular deposits.
With 529 plans, you’ll benefit from special tax benefits like 5-year gift tax averaging and tax-free qualified distributions. The IRS doesn’t specify any 529 plans contribution limits, and up to $15,000 per year qualifies for the annual gift tax exclusion.
But even better still, setting up a 529 plan will also help you to teach your child about saving and investing.
By involving your child in their own 529 plan , you’ll be able to show your teen or young person first-hand how much power compound interest holds. You’ll also be able to demonstrate how saving a little but often can generate big results — and depending on the type of 529 plan you go for, you can even show young adults how stocks work.
With real money at stake, you’ll be able to actively engage your children and make them want to learn about finances in a way that money games or educational apps never could.
Want to learn more about 529 plans and how they can be used to save for your child? Check out our 529 Savings Calculator.
Coverdell Education Savings Account (ESA)
Coverdell ESAs work a lot like 529 plans. They’re a financial vehicle that parents and other relatives can use to save for education-specific expenses over a long period of time. Then when it’s time to enroll in college, you and your child can withdraw that money to pay the bill.
The main difference between a 529 plan and a Coverdell ESA is that a Coverdell account has a broader definition of what counts as a “qualified educational expense”. Coverdells are also able to cover things like uniforms, tutors, and special needs services.
But with that added flexibility, you’ve also got to accept lower contribution limits. There are stricter rules on how much money you’re allowed to invest in a Coverdell ESA annually, with the limit in 2021 being capped at just $2,000 per year. That means you won’t be able to save as much money with a Coverdell account as you might be able to with a 529 plan.
You should also be aware that unlike 529 plans, Coverdell ESAs have income limits. As a result, not everyone will be eligible to contribute to a Coverdell ESA.
But just like the 529, a Coverdell is a great way to save for your child’s future and watch their college fund grow alongside them. As they get older, you can teach them more about how and why you’ve been saving, how you’ve budgeted to do it, and why.
That will reinforce all of the fundamentals of financial literacy: budgeting, saving and interest.
A Roth IRA is a retirement account that parents sometimes also use to save for their kids and help teach them about finance along the way.
Roth IRAs are tax-beneficial accounts that enable you to store long-term savings.
The major benefit here is that you can withdraw your Roth IRA contributions tax-free at any time. But if you withdraw any earnings from your IRA before you turn 59 ½, you’ll be taxed on those earnings and have to pay a 10% penalty.
Generally speaking, qualified education expenses are an exception to that 10% penalty rule. But even if you withdraw to pay for educational expenses, just remember that you’ll still owe taxes on the earnings portion.
Unlike 529 plans or Coverdell ESAs, Roth IRAs are not education-specific. Once you turn 59 ½, you can take cash out of a Roth IRA for whatever you want (not just college expenses). That means you can set up a Roth IRA to save for your child’s college expenses, but then repurpose the account and use it for something else after they graduate.
Like other college savings vehicles, Roth IRAs are a super useful way to show your kids first-hand how stocks and securities work. You can invest in securities early on, and then your children can watch how an investment is realized — which will help them fund their future.
One point to bear in mind is that Roth IRAs do cap your investment potential. In 2020, the IRS set up a contribution limit of just $6,000 per year (or $7,000 per year if you’re over 50). That means if you’re saving for the Ivy League, a single Roth IRA might not put a dent in the tuition bill.
Another point to remember is that Roth IRAs have income limits — and so not everyone is eligible to contribute to one in the first place.
Financial literacy isn’t a skill you’re born with. Money management can be tricky, and a lot of kids head off to college without a proper financial education. That’s why you’ve got to give your kids the personal finance tools and financial knowledge they need to succeed — and that journey starts early on.
Make sure you teach them fundamentals like budgeting, how interest works, and how to save. But more important still, you’ve got to show them how it’s done. Fortunately, you’ve got plenty of financial vehicles open to you that will not only help you teach your kids financial literacy but will help you save for their future college expenses, too.
Ready to learn more about how savings tools like 529 plans can help you start funding your child’s financial independence? Try out our 529 Savings Calculator.