The Greatest Financial Lesson You Can Teach Your Children
It is natural for parents to want the very best for their children. But we often make the mistake of trying to protect and shelter them rather than really sharing valuable life lessons with them.
If you ask most people what they want, invariably they will come to the conclusion that freedom is what we all strive for. And we will never have complete freedom until we have financial independence. But in our materialistic world where the emphasis is on getting more and more material things, we often become financial indentured slaves. There is only a very small percentage of Americans that retire financially secure.
It is not only possible to retire financially secure, it is rather easy. Easy if children are taught the greatest financial lesson they can ever learn.
Before we get to the lesson, consider this question. Person "A" starts a tax deferred savings plan when they are 20 years old. They invest $3,600 per year and the account earns 8% per year. At the end of 20 years, this person stops making additional investments but lets the account continue to grow. Person "B", wanting to obtain more material possessions, waits until they are 40 to start a tax deferred savings plan. Since they did not start younger, this person invests $7,200 per year and the account earns the same 8%. This person continues to invest $7,200 for the rest of their life. The question is how long will it take person "B" to match the investment balance of person "A"?
The answer may surprise you. Person "B" will not live long enough to ever catch person "A" who started their savings when they were 20. Let's assume that they both live to 90. Here is what things look like. Person "A", invested a total of $72,000 and at age 90, assuming he never made any withdrawals, he would have $7,726,716. Person "B" who started investing when they were 40, would have invested $360,000 but would only have a balance of $4,466,837.
Now for the most important financial lesson you can teach your children. It is the power of compound interest. Person "B" who waited until they were 40 to start investing, invested 5 times as much as person "A" who started when they were 20. But their total nest egg was some $3 million less.
If we looked at what happened at age 70, person "A" who started at age 20, would have a nest egg of $1,657,000 and could withdraw over $122,000 per year without touching the principal. Person "B" who started at age 40 would only have a balance of $888,090 even though he would have invested 3 times as much. And if he wanted to withdraw just the income, he would only have half as much to live on each year.
So teach your children about the power of compound interest. The earlier they start saving for their future, the less they actually need to save and the more financially secure they will be later in life.
You can also teach them a valuable lesson about choices they make when their income increases. When they get a raise, most people raise their expenditures to consume the entire increase in pay. A much smarter strategy would be to save 50% of the raise and let the balance go to enjoy a higher standard of living. If your children did that, they would squander less money and they would also find they would probably be able to retire much earlier in life and they would have sufficient funds to live the life of their dreams.
Let's look at the power of this simple strategy. Let's just work with Person A. Assume that at age 20, he has a job that earns him $30,000 per year and that he will get a 5% annual raise. If he increased his contribution to the tax deferred savings plan by 50% of his raise for the same 20 year period as the initial contribution (after investing it for 20 years he would make no further investments) at age 70, his total additional investments would have been $22,904. His balance at age 70 would be $2,170,743 and he would be able to withdraw $156,129 each year without touching any principal. Quite the return for a very little extra savings.
You need to have a little chat with your children and teach them the financial facts of life.
© 2008 John Chancellor