How to Pull Your Own Financial Act Together

Pop quiz: In 10 seconds or less, name the three most important financial steps every mom and dad should take to give their child the right start in life.

Okay, time's up.

If you're like most parents, building a college fund tops your list. So, what's number two? Hmmm.... What was that again? And number three? No answer there either?

Therein lies the problem. While figuring out a way to pay for college is an undeniably worthy goal, it's only one of several you should pursue  -- and not even the one that should top the list. "The single most meaningful action we can take on our children's financial behalf is to reexamine how we are using money in our households," says Sharon Danes, Ph.D., a professor at the University of Minnesota who specializes in children's financial development. "Since children learn about money primarily by example, we have to make sure the beliefs and practices we're passing on are the ones we really want our kids to live by."

Here, the rest of what you need to do.

Get Your Priorities Straight

In a perfect world, you wouldn't have to choose between saving for your children's college education, your own retirement, and, say, fixing the roof; you'd have more than enough money to take care of expenses today, save for tomorrow, and perhaps even spring for a cruise to the Bahamas. Unfortunately, only a handful of parents live in that world. The rest of us struggle mightily to squeeze a few extra dollars out of already-tight budgets and make compromises on our goals along the way.

Since few of us can do it all, which financial goal should get top priority? Virtually unanimously, financial planners urge parents to save for their own retirement first. There are numerous sources of money for college besides your own savings  -- grants, scholarships, work-study programs  -- but only you can come up with the cash to see you comfortably through retirement. As Ray Loewe, a Marlton, NJ, financial planner, puts it, "You can always borrow money for your kid to go to college, but no one is going to lend you money to retire on."

Additionally, retirement accounts typically offer substantial tax advantages that allow your savings to grow much faster than they would in an ordinary investment account. Plus, if you invest through a 401(k) account, your employer will likely match all or part of your contributions. And colleges rarely count retirement assets when determining a family's financial-aid eligibility.

But if you need to, you'll still be able to tap those retirement accounts to help pay for college. Most companies allow you to borrow against the money you have in your 401(k) plan, and starting this year, you can also withdraw money from an IRA to pay for higher-education expenses without incurring a penalty. "Don't count on raiding your retirement plan to pay for college," says Chicago financial planner Hope Feinglass. "But if you're conflicted about saving for retirement because you're afraid you'll fall short for college, it's extremely comforting to know that IRA money can be used for a child's college tuition too."

Make Time Your Ally

No one's suggesting that you abandon saving for college altogether. Setting aside even small amounts can make an enormous difference, particularly if you start early. Time is a college investor's best friend because of the way your profits compound over the years  -- as time passes, you not only earn money on your original investment but on your earnings, and then on your earnings' earnings.

Say, for instance, you manage to scrape up $100 a month, starting the year your daughter is born until she turns 5, at which point you decide that the money is needed more elsewhere. Assuming the account earns 12 percent annually (about what the stock market has returned on average over the past 50 years), your $6,000 total investment will be worth more than $35,000 by the time your daughter turns 18, roughly enough to cover the estimated costs for two years at a state school in 2016. Now consider what happens to your friend who doesn't intend to start a college fund for her son until he turns 13. Since she's waiting to save until she's at a more financially secure stage in her life, she figures she'll be able to set aside $200 a month. Assuming that college fund earns the same 12 percent a year as yours, it will be worth around $16,000 by the time her son turns 18  -- less than half what your fund would be worth, even though she'll have invested twice as much over the same number of years.

The bottom line? "When it comes to investing for college, starting early is a lot more important than the amount you save," says Sona Haratunian, a first vice-president in financial planning at Prudential Securities, in New York City.

Get Help with the Heavy Lifting

More than half of all parents who are currently saving for college put their money into U.S. savings bonds, certificates of deposit, and other so-called safe investments, according to a recent poll in Money magazine. Big mistake. "Since most parents aren't going to be able to save enough money to meet the full cost of college, they need to leverage the investments they do make as much as possible," says Ray Loewe. "That means putting as much money into stocks as you can stomach in the early years."

Just consider: Over the past 50 years, Treasury bills and intermediate-term bonds have returned just 4.9 to 6.1 percent a year, according to Ibbotson Associates, a Chicago investment research firm. That's barely enough to keep pace with the 5.5 percent rise in college costs over the past five years, let alone grow your savings fast enough to make a real dent in tuition bills. Meanwhile, the stock market gained an average of 12 percent a year over the same 50 years.

Though it is true that stocks can suffer some alarming dips in value over short periods, in the long run they're no more likely to lose money than CDs. In fact, there has not been a single 10-year period over the past 50 years when stocks declined in value. And you can reduce your chances of short-term losses once your child gets within a few years of college by adding a bond fund to your investment mix.

To get the best returns with the least risk, restrict your purchases to stock mutual funds that have been around for at least five years, which is a long enough period to see how well the fund has fared in both good and bad markets. Then, among those, favor the ones that have consistently earned more than the average fund, while keeping volatility low. To find the information you need to make a sound choice, look over reports by Chicago fund research company Morningstar Inc., which are generally available at the library, on the Internet at www.morningstar.net, or by subscription. (For some promising candidates screened specifically for Parenting by Morningstar Inc., see "Fundamental Investments.")

Make Your Kid a Millionaire

If your son or daughter has any earned income at all, you may be able to score big by putting at least a portion of those wages into an IRA in your child's name, since you'll probably have 40 or 50 years for profits to compound in the account. For instance, an investment of $1,500 a year from summer jobs at ages 13 through 18 will grow to a cool million ($1,020,709, to be precise) by the time he turns 65, even if he never invests another penny, assuming the account earns 10 percent annually.

Of course, unless your little one is a kiddie model or actor, you probably won't be able to open the IRA until he's old enough for a paper route, babysitting job, or other legitimate form of employment. If you have your own business, though, it should be relatively easy to find jobs that even an elementary-school child can tackle to earn money, such as filing, addressing envelopes, or helping to clean the office. It's also a good idea to involve your child in deciding where to invest his IRA money. Says Feinglass, "That way the account not only becomes a powerful tool for making money, but also a powerful vehicle for teaching the rudiments of investing."

Collaborate with Your Child's Teachers

Research shows that adults who grew up in states that mandate personal finance education in high school are saving nearly 5 percent more money than their peers and have a net worth that is higher by roughly a year's worth of earnings, according to a study by the nonprofit National Bureau of Economic Research, in Cambridge, MA. And although "children are most receptive to learning economic concepts between 8 and 12," says Barbara Heinzerling, a consumer-science professor at the University of Akron, most public school programs that do exist are at the high school level.

"Lobby the school board and raise the issue with your town's PTA," suggests Dara Duguay, of the JumpStart Coalition (www.jumpstartcoalition.org), which has compiled a listing of sources for curricula for kids from kindergarten on up.

Set a Fine Example

Given the spotty nature of personal-finance instruction in schools, it's not surprising that most teenagers report that they've learned whatever they know about money at home. Researchers say that very little of that knowledge comes from formal instruction, but rather from children's observations of the way their mom and dad manage money. "Therefore, parents who want to teach their children good money habits first need to become smart financial managers themselves," says Sharon Danes.

If you whip out a piece of plastic whenever you buy something at the store, your child learns that it's normal to live on credit. If your family squeaks by from paycheck to paycheck, your child won't get a firsthand look at any of the benefits of saving.

Don't worry if until this moment you haven't been a paragon of financial prudence; few among us have. But it's not too late to mend your ways. Resolve to cut up all but one or two of your credit cards (the average American has 15); sit down with your spouse to devise a livable budget; and take a disciplined approach to saving by enrolling in an automatic investment plan.

The prospect of getting your financial act together should by itself be sufficient motivation to get you going. If not, just remember that the kids are watching.