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Financial Life Advisor
Self-Employed with a Baby on the Way
My wife and I are 28 and 30. We are expecting a baby in 6 months. We have approximately 4 months living expenses saved for emergency expenses (in a traditional savings account, 1% interest). I would feel more comfortable with 6 months savings. My wife has a retirement account from her previous job with about $ 12K in it and I currently do not have any retirement. We are self-employed and looking to set up some type of retirement plan for me and transferring her balance to something that we can continue to add to. What type of accounts would you suggest we look into? Should we transfer our emergency funds into something that pays a little more interest? Also, what should we expect to set aside for a 529 college account for the baby per month?
J.H .from San Antonio, TX J, congratulations to you and Mrs. H on the upcoming baby. I read somewhere that on average when men have their first child and it is a baby boy, his income will generally rise after the birth. Interestingly enough, the same thing does not happen when a baby girl is born. I am not sure why that is or why that is relevant, but it is nevertheless interesting to me. Nevertheless it is good you are thinking about retirement and college now.
Having a fully funded emergency fund is the foundation of any financial plan. Cash flow problems are one of the top reasons most small businesses fail. Being self-employed, your small business and personal finances are intertwined. The emergency fund is the buffer between you and desperation. If you have no cash cushion, stress, anxiety, and bad decisions usually follow. You would not want to sell assets in a fire-sale, so the emergency fund is critical.
As a rule of thumb, three to six months of expenses in cash is recommended for most people. There are certain factors you should consider regarding how much of an emergency fund you need for your particular situation:
If you have a stable job (like government employment), move to the shorter end of the scale.
If you have a stable income (not on commission), move to the shorter end of the scale.
If you have a two income household (different employers), move to the shorter end of the scale.
If you have a low debt load (credit cards, student loans, mortgage, car loans, etc), move to the shorter end of the scale.
It sounds like in your situation that you would need to be on the high end of the emergency fund scale. You might even want to shoot for over six months, but for sure, I would recommend at least six months. Keep in mind that the emergency fund is to be set aside outside of normal savings. You should save additional cash for vacations and other purchases. Do not use the emergency fund as a revolving line of credit to yourself.
Your emergency fund should be highly liquid and stable. The emergency fund is not an investment for growth, but is instead an insurance policy against cash flow problems. As tempting as it may be to look for a higher yield, you should stick with something safe. Those (which ones? The higher ones?)investment vehicles are not paying much interest right now. Generally, I recommend you look for a high yield FDIC insured savings account. I have some clients who have decided to purchase long term CDs for the higher yield, knowing that they may have to pay an interest penalty to access the funds early. Doing that might also help keep you from accessing it for anything other than an emergency. Make sure to read the fine print on exactly what the penalties are for early access.
Once you have the emergency fund squared away, you should start savings for retirement. You and your wife are still young and by creating the habit of saving for retirement, it is much more likely that you will continue to save through thick and thin. Being self-employed means you have access to several different retirement accounts. The one best suited to you will depend on several factors, the most common ones being if you have employees and at how much you can afford to save versus your income.
Here is a brief synopsis of the main retirement plans you could consider: Employee (EE) contributions are what you can put in, and employer (ER) contributions are what your small business contributes. Please recognize that for you, both EE and ER funding is effectively the same, but for your employees, that is not the case. They elect to make salary deferrals (EE contributions) which they pay for. I will ignore age 50+ catch ups because they do not apply to your situation. In this example, all numbers are for 2009, and some tax rules are being ignored for simplicity. Consult a tax professional for more details.
Traditional or Roth IRA
EE can contribute up to $5,000 per year to either a Roth or traditional IRA. This option has lots of investment flexibility and generally low cost. This can be done with or without consideration of employees. Max contributions for both of you would be $10,000.
SIMPLE IRA
EE can contribute $11,500 per year with an ER 3% match. This option has lots of investment flexibility and generally low cost. Plan participation must be made available to most employees and the ER match is paid by the employer. Max contributions for both of you would be $23,000 + 3% of salaries.
SEP IRA
EE contributes nothing. ER contributes up to 25% of compensation for all employees (including the owners) up to $49,000. This option has lots of investment flexibility and generally low cost. Most employees must be included in the ER contribution based upon their compensation. Max contributions for both of you would be $98,000.
401(k)
EE can contribute $16,500 per year with numerous possible match and ER contribution options. ER + EE funding can add up $49,000 with lower income requirements than a SEP IRA to reach the maximum funding and possibly a lower ER contribution for other employees. Investment flexibility is more limited, and there is more significant administrative expense than IRA based plans. Max contributions for both of you would be $98,000.
My recommendation is to start with old fashioned traditional or Roth IRAs. You should be able to roll money from a previous employer into a traditional IRA and add to it. If you find you can contribute more than $10,000 per year, you should open a SIMPLE IRA if you have employees, and a SEP IRA if you don’t. Once you have some employees and significant earnings, a well designed 401(k) is probably the best bet. There are many considerations which are too numerous to go over here, so I recommend you consult a CPA on what vehicle is best for your situation, and reevaluate annually as your business grows.
J, you also asked about college savings for the new arrival. The basic question to ask yourself is how much of the college expenses do you want to pay for and what type of institution do you intend for your child to go to? The cost difference between a community college and private university can be quite large. Some parents want to pay for all college expenses and others feel some, or all, of the burden should be borne by the student.
For this example I am going to assume you want to pay for 100% of your child’s tuition, fees, room & board. Also I am using the average costs from the College Board’s 2007-2008 average costs. The annual rate of inflation is from FinAid.org at 8%. The average investment return used will be 7%.
Annual Costs Current Cost Cost in 18yrs Annual Savings to Meet Goal (4 yrs)
Two-Year Jr. College* $2,361 $9,434 $1,110 or $93/month
Four-Year In-State $13,589 $54,302 $6,389 or $532/month
Four-Year Private $32,307 $129,099 $15,189 or $1,265/month
*Assumes student lives at home.
Many students (about half) end up qualifying for grants, scholarships, or some other type of assistance. Even if you cannot afford to save as much as you would like to, some savings is always better than no savings. To get started, I would recommend looking at Vanguard if you live in a no-income tax state (like TX). Otherwise, you should look at your state-sponsored 529 plan. I recommend you choose an age-based portfolio unless you have a financial professional constantly monitoring it.
Posted by Ben Gurwitz on 14th August, 2009 | Comments | Trackbacks
Tags: Financial Planning, College Savings, Retirement Accounts
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