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I love when readers ask questions that involve a series of financial issues.
The reason that I do is that no area of our financial lives takes place in a vacuum. Each subpart of our finances affects all the others.
We received just such a set of questions from a self-described Average Joe:
Hi Jeff and the team,
I have few questions you may address, of course if you don't mind. Just a bit of background: I am almost 33 with wife and 2 small kids, household income is ~100k, mortgage, car loan, school loan – average Joe…
1. What insurance is appropriate for my situation: term or whole life and why?
2. What would be the best way to save for kids college assuming I have ~14 years timeframe?
3. Any additional “smart money” tips for a guy like me.
4. What is your opinion on strategies like “SweepStrategies.com” or “truthinequity.com” to get out of debt faster than a traditional approach like Dave Ramsey?
Thanks in advance,
Thanks for the series of questions, Yuriy, and for the background on your family. It makes it easier to answer the questions in a way that's relevant to your circumstances.
Let's look at each question individually.
1. What insurance is appropriate – term or whole life – and why?
For the great majority of people, term life insurance is the best way to go. It's not just less expensive than whole life, but a lot less expensive! We're talking something on the order of ten cents on the dollar. That's huge.
The primary reason for the difference in price is the fact that whole life insurance includes an investment provision.
On the surface, that may seem like a winning combination. You're not only maintaining life insurance for your family, but you're investing at the same time. As the saying goes, that's killing two birds with one stone.
But as good as that looks, it's usually not working to your advantage. First, the investment provision with whole life insurance involves a lot of fees. The fees are heaviest in the first few years of policy, which also means that your cash value accumulation is minimal. That means that whole life insurance policies work against you for the first few years.
But even more important is that whole life insurance policies are generally a poor way to invest money.
In most cases, you would do far better if you purchased the less expensive term policy, and invested the difference (what you would have paid for whole life) on your own. Simply by investing the money in an S&P 500 index fund, you can outperform whole life investments, and by a wide margin.
As a young man with a young family, Yuriy would be better off taking a long-term, term insurance policy. He can get one covering the next 20 years at a small fraction of what it will cost for a whole life policy. The lower premium will enable him to purchase a much larger amount of life insurance. That's incredibly important, because with a young family he's at that point in life where his need for insurance is greater than it will ever be.
And by the time the policy expires, his kids will be adults, and his need for life insurance will decline.
2. What would be the best way to save for kids college?
Yuriy indicates that he has a 14 year time to prepare for his kid's college educations. That means that now is an outstanding time for him to be asking this question!
The best way for him to invest for that education is through a 529 Plan. It works like a Roth IRA, except that it's used to build funds for their children's college educations, rather than for retirement. You contribute to the plan, and though your contributions are not tax-deductible, the investment earnings on the account accumulate on a tax-deferred basis.
When it comes time to withdraw the money, it can be taken out free of both regular income taxes and penalties, as long as the money is used to pay for qualified education expenses. That includes tuition, books, fees and room and board. Certain other expenses, such as laptops and outside resources may also be considered as qualified, as long as they are required by the school or the course curriculum.
(Funds withdrawn for purposes unrelated to qualified education expenses are subject not only to regular income tax, but also a 10% penalty.)
Technically speaking, there is no maximum contribution limit that applies to a 529 Plan. However, most people limit their contributions to $14,000 per year, per child. That's actually the maximum annual limit for gifts. Beyond that amount, you must either pay a gift tax on the amount transferred, or you have to file IRS Form 709 – United States Gift (and Generation-Skipping Transfer) Tax Return to avoid the tax.
If you save $14,000 per year for one child, for the next 14 years, you will have saved $196,000 – plus investment earnings. That's a sufficient amount of money to pay for a four-year college education at some of the better schools in the country.
Any additional “smart money” tips?
Actually, I have dozens! But I'll try to limit my suggestions to a few that I think are most important:
- Be consistent. There's no way to overnight riches, so you have to be prepared to work your financial plan for many years. That means guarding against the hot and cold cycles that can derail all of your plans and efforts.
- Use debt sparingly. Debt is a wealth killer. Not only should getting out of debt be a priority, but it should also be avoided going forward. Limit it to a home mortgage, and the occasional car loan.
- Don't get fancy with your investments. Stay with funds, particularly index funds. They track the market, rather than investing in the latest fad or trend stocks. That makes you more money over the long term.
- Investment fees matter! Keep them as low as possible, and that will improve your investment returns. Index funds have some of the lowest investment fees available, which is another reason why they should be favored in your portfolio.
- Don't get sidetracked. It's often tempting to think that somebody else's has figured out a “better way” to wealth. Maybe they have, but it might not work for you. Stay with what you know, and work to gradually get better at what you do.
3. What About Get-Out-of-Debt Strategies?
Yuriy asks about debt elimination strategies, like “SweepStrategies.com” or “truthinequity.com”, as compared to traditional approaches, like Dave Ramsey.
I must confess upfront that I'm not really familiar with what those two services do to reduce your debt. I didn't peruse both sites, and got the impression that they are mortgage elimination programs, that are based on using home equity lines of credit or credit cards to accelerate the early payoff of your mortgage. But at the same time, I found both sites to be vague in explaining exactly what the strategy is.
Be that as it may, ultimately there's no substitute for paying off debt, other than doing it out of your income or other financial resources. For that reason I prefer more traditional debt elimination strategies, such as those offered by Dave Ramsey and other financial experts.
What I like about Dave Ramsey is his simplicity. The Debt Snowball method is not only easy to understand, but it recognizes the role that emotions play in the process. For example, he advises that you start by paying off your smallest debt first. This makes sense, because it is the most doable strategy. Once you pay off that smallest debt, you are then empowered to take on the next smallest debt.
This method sets you up for a series of relatively small victories, that will give you the confidence to achieve bigger ones.
Just about any strategy to get out of debt is a good one as long as it works for you. But simplicity is a major factor, and that's why favor more traditional approaches.
I hope this answers all of your questions Yuriy, as well as those readers who have similar questions. But keep them coming in, and I'll do my best to answer as many as I can.