The Financial Advice You Need Now!

Amercian Baby Magazine, January 1988

You're home from the hospital now -- you, your spouse and your new baby.  Parenthood is no longer a fantasy, and you're proud of how well you're doing.  Then a close friend casually asks, "Have you updated your will?"  "Uh, not yet," you say.  (You don't even have a will).  A few weeks later, after you return to work, you overhear a co-worker proudly describing his "educational trust" for a newborn daughter.  You begin to wonder what you’ve missed.

In my experience as a family lawyer, I'm often surprised at how many new parents prepare physically and emotionally for the birth of their child but are unaware of how to prepare for their new legal and financial needs.  A savings account and pension aren’t enough; you also need wills, life and disability insurance, and perhaps an educational fund. 

Why You Need A Will

Life Insurance -- What Kind and How Much?

Why You Need Disability Iinsurance

Do You Need An Educational Fund?

 Why You Need A Will

Contrary to a widely-held belief, dying without a will doesn't mean your property passes to the government.  Instead, your state’s laws of “intestacy” determine your beneficiaries.   In most states, half of non-jointly owned property (titled in your name alone) passes to your spouse, the other half to your child.  Furthermore, the surviving spouse has first priority to be named executor of the estate.      

 But what happens if you and your spouse die together in a plane crash?  Or what if your spouse dies soon after you, also without a will?  Your child would then receive your entire estate, but a court would choose the child’s legal guardian.  Judges usually choose the nearest relatives of the child, often causing titanic court battles between sets of grandparents.  Even more upsetting to families are those situations in which the child's closest living relative is Uncle Harold, a tambourine player with the Hare Krishnas. 

To avoid these kinds of problems, you will need a will.  A properly drafted will names your beneficiaries, your child's guardian, and a trustee for the child’s estate while he is a minor.  And although joint wills are legal, both husband and wife should have their own will; otherwise, you run the risk of being unable to deal with changed circumstances arising from the death of one spouse.   

For some people a comprehensive estate plan is necessary.  This is an integrated design of wills, trusts, lifetime gifts, and life insurance that gains maximum benefit from the tax laws.  Currently an individual can leave up to $600,000 to anyone free of federal estate tax, and an unlimited amount to their spouse (the marital deduction).  Life insurance, pension funds and home equity, however, can place many "middle-class" people above the $600,000 limit.  This may generate a federal estate tax upon the death of the second spouse to die, who will not have the marital deduction available.  In such cases, an estate plan can reduce or eliminate the tax you might otherwise have to pay.

When choosing a lawyer to draw up your will, ask friends and co-workers for references.   Lawyers generally charge a flat fee for routine wills and estate planning -- often under $100 for each will.  Almost any lawyer can draw up a simple will, so don’t hesitate to ask a lawyer you’ve met through a different connection ¾ like a house settlement.  Preparation of a detailed estate plan and tax-saving wills, however, should be done by a lawyer with experience in this area.  Such work is done on an hourly fee basis and can cost in the $500-$1,000 range.   

Life Insurance -- What Kind and How Much?    

Life Insurance Glossary

The purpose of life insurance is to guarantee your family a reasonably comfortable life if you die young. Until the birth of your child, you may not have needed it; if either you or your spouse died, the other could still be self-supporting

Once a child arrives, however, things are different. Whether or not both parents work, the death of one parent can mean substantial hardship for the survivor who must bear child-raising expenses alone. 

What type of life insurance is best for you?  Today there are hundreds of life insurance “products” on the market.  Many are marketed as investments and tax shelters. But if you eliminate the hype, there are really only two major types: term and cash value. Term insurance is simple: you die, they pay As the name implies, I’s bought for a specific term: one, five, ton, 15, or 20 years, renewable annually. It’s not an investment.  It buys the greatest amount of protection for the premium dollar, and premiums rise as you get older.

There are now many different types of cash value policies: whole life, modified whole life, universal life, single-premium life, and variable life (see glossary at left). Cash-value policies alone rarely provide the insured with adequate coverage. The most common am whole life and universal life. With these policies you pay fixed premiums that build a cash value that is returned to you at a designated time, provided you live long enough to collect.  Such policies are much more expensive than term insurance; however, they do offer steady (if high) premiums, capital appreciation, loans, and tax-deferred income.

Most insurance agents will encourage you to buy cash-value rather than term. This isn’t surprising since their commission is five to ten times higher on a cash-value policy than on a term policy.  And agents will point out, quite rightly, that after years of paying term premiums, you’ll have nothing accumulated. With whole life or universal life, however you would have a significant sum in 15 or 20 years, and you could draw on this money. But term premiums aren’t wasted—no more than car insurance is “wasted.” You’re buying protection. 

For example, a typical whole life or universal life policy in the face amount of $200,000 for a 30-year-old nonsmoking man would cost about $2,500 a year.  A 20-year-old woman would pay about $2,200. The same coverage In a renewable term policy would cost approximately $200 to $300 a year. (The cost is even cheaper if you can buy a group policy through your employer or professional association.) True, term premiums rise every year, but it wouldn’t be until year 20 that the premium would equal the first year’s  whole-life premium. And in 20 years with your kids grown, you might not need any more coverage.

In two-income families, both husband and wife need to be insured, since there are two incomes to replace. For this reason term insurance might be most attractive; two cash-value policies would be extremely expensive.  By the way, children do not need life insurance since they have no income to be replaced, and their parents normally do not count on them hr support. 

How much coverage do you need? Most people who have life insurance don’t have enough.  A recent study showed that the average coverage amount for married people with children was only $80,000.  Yet most people with young children usually need at least $200,000 of coverage.

Life insurance agents often give you formulas to calculate your optimum coverage, such as ten times your annual earnings.   Other agents tell you to buy “as much as you can afford.”  Evaluate your financial situation and goals before blindly accepting any formula. 

Begin your evaluation by calculating the family’s annual after-tax income deficit if you died tomorrow.  Deduct one third from this sum, the amount most people spend on themselves. Ideally you should buy enough coverage to give your spouse a lump sum that will, if invested, equal this net annual income deficit. Deduct from this lump sum the other assets available to the family after a death— investments, savings, pension death benefits, IRA accounts.

Then consider other issues, such as whether the surviving parent will work or stay at home with the child, the child’s probable educational expenses, and whether to pay off your home mortgage.  Depending on how you answer these questions, you may add to or subtract from your ideal coverage amount.

Be aware that if you own a home, you may already have mortgage life insurance. This is a term policy for the amount of the declining balance of your home mortgage loan and is required by mortgage lenders if the original down payment is less than a specified amount ¾ usually 25 percent.  You pay this premium as part of your monthly check to the lender. 

Be flexible. The "ideal" coverage amount—a lump sum that will generate enough interest to meet all your needs—may be too expensive for you right now. If so, choose a lower coverage amount that will still meet your family's needs if both the interest and principal are gradually spent during the necessary period (18 years if your child is a newborn).

No matter what type of insurance is best for you, or how much you can afford, get some now, for both you and your spouse, while you're healthy.  With most policies, once you’re insured, you can’t be cancelled as long as you pay the premiums. But if you wait until you develop health problems, you may find life insurance extremely expensive or even impossible to obtain. 

And don’t forget to review your coverage every two years to keep it up-to-date.  The birth of another child ro a big raise can significantly change your insurance needs. 

Why You Need Disability Insurance 

According to insurance company figures, there is a 50 per cent chance you will be disabled by injury or illness for at period of at least 90 days between the ages of 35 and 65.  And statistics show that almost half of home mortgage foreclosures are due to homeowner disability.

Given these facts, it's unfortunate that so many prospective and new parents don't have disability insurance, which will pays a weekly or monthly benefit as long as the policyholder remains sick or injured.  The payments begin after a waiting period, usually 30 days. Once you develop a sickness or disability, of course, it's impossible to obtain such insurance.  Therefore, it's especially important that you get a non-cancellable policy now, while you're healthy.    

Many large employers, unions and professional organizations offer group disability policies; you can also buy an individual policy through a general insurance agent.  Although group policies are always cheaper, they can be cancelled if you leave your employer or other group, or if the group cancels the master policy.  Individual disability policies, on the other hand, are non-cancellable and therefore more expensive.  If you can, buy both: a non-cancellable individual policy for the minimum coverage amount you need, and a cheaper group policy for additional coverage.  This is called "stacking" policies. 

Policy definitions of "total disability," "partial disability" and the provision for the payment of "proportionate" benefits vary from company to companhy and should be your major point of comparison among disability contracts.  For instance, the definition of total disability in some group policies requires a person to be bedridden before benefits will be paid.  Yet you may be ambulatory and still not able to do your job. 

And don't try to buy complete "replacement" coverage for your salary -- an amount of money equal to your gross monthly salary.  You'll find this to be prohibitively expensive.  Instead, aim at that minimum amount which would still allow you to meet your essential monthly bills -- home mortgage, car payment, groceries, etc.  You'll have to expect to dip into savings for anything extra.  But you can also cut your cost considerably by buying a policy with a sixty or ninety day waiting period. 

Do You Need An Educational Fund? 

The ultimate financial challenge of parenthood is paying for a child’s (or several children’s) college education.  The average cost of a private, four-year college education is now over $50,000.  Even a state university education can cost more than $25,000.

You can pay these costs out of your general savings -- if you have it at the time.  Or you could start a disciplined investment plan now -- and in 18 years, sending your kid to college will be (relatively) painless.  Consider this: if you invest $2000 for 18 years at six percent annual interest, you will have accumulated $65,000 by the time the child starts college.

If you set up an educational fund, separate it from your regular savings account.  When a child’s money is mixed in with his parents’, the temptation to spend it becomes too great.

Unfortunately, income taxes can significantly reduce the growth of your fund ¾ even if you give the money to your child under the Uniform Gifts To Minor Act (UGMA). Under current law, unearned income (dividends and interest) of children under age 14 which exceeds $1000 is taxed to the child at the parents' marginal tax rate.    

If your fund is generating more than $1000 in income annually, simply start investing in non-income producing assets ¾assets that defer income until after your child is 14.  For instance, there are many stocks and "equity" mutual funds which produce little or no dividend income but have good prospects for increasing their value.  And once the child reaches age four, you can purchase U.S. EE savings bonds.  EE's have a ten-year maturity rate and generate no taxable interest income until redeemed at maturity (when your child is fourteen).  They are also extremely safe, with money-market interest rates.  And of course there are also the traditional tax-free municipal bonds and bond funds.

Another alternative is the establishment of a trust fund.  If income such as dividends and interest is generated by a trust and not distributed (given to the child each year) then the trust itself files an income tax return and pays taxes at the trust rate.  Currently, this rate is 15% for income up to $5000 a year.   

A trust also has other advantages over a custodial account for your child.  Under the law in most states, the money in a child's custodial account can be withdrawn by your child at  age 18.  If the child wants to buy a Porsche instead of going to college, there’s nothing you can do about it.  A trust, however, can provide many options for distribution of the funds, including a specific age for final date of distribution (e.g., age 25) and conditions for distribution of the principal.  You'll need a lawyer to set up the trust and explain the numerous tax and legal consequences to such an action.   

The long-term financial responsibilities of parenthood can seem overwhelming at first, and many parents are reluctant to face them.  But taking the steps outlined above will ease your burden considerably.

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© 2002, Daniel N. Steven