Becoming a Parent: The Financial Considerations
Once you have a child, financial planning for the future becomes even more essential. How will you finance child care, medical bills, food, education, clothing, toys, and education savings? What will you need to spend money on and how much will each item cost? Here is some of the information you will need.
This Financial Guide provides you with guidelines on handling the expenses a child brings. Obviously, we cannot offer precise costs because the costs hinge on variables such as family size, family income, and geographic location. However, we can suggest some rough (often very rough) estimates for the average sized family of two adults and two children and to at least provide a starting point for your planning. Obviously, the costs for later years will go up as inflation takes its toll.
Knowing what to expect will allow you to plan for the future, thereby increasing your chances that you will not fall short of your financial goals. Indeed, this is the time to review and update, if necessary, your financial plan.
Related Guide: Please see the Financial Guide: YOUR FINANCIAL PLAN: Getting Started On A Secure Future.
Here is a breakdown of the items you'll need and an estimate of their cost. The costs are categorized chronologically, according to the child's age.
Note: These estimates are for a first child. Bear in mind that second or third children will cost less than the first, since you will already have purchased many of the items you need. If you have three or more children, you will spend about 22% less on each child. Also, note that, in the case of a multiple birth, expenses will be higher than (although not double) those of a single birth.
Government estimates say that a middle income family in 2013, defined as having an annual income between $61,530 and $106,540, will spend a total of $245,340 to raise a child to age 17. This figure represents a 1.7 percent increase from 2012 and does not include expenses incurred beyond the age of 18. If you include the cost of college, whether public or private, that cost goes up significantly. And, families that earn more generally can expect to spend more on their children.
Planning Aid: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, see the Financial Calculator: The College Savings Plan Calculator.
Related Guide: If you are ready to start planning now for your child's future college education-and indeed the time to start is now-please see the Financial Guide: YOUR CHILD'S COLLEGE EDUCATION - How To Finance It.
Here are the costs you can expect up to birth and during the first year:
Note: For a second or third child, you will spend much less on furniture, clothing, and toys, but health care, child care, and food will remain the same.
According to the Transforming Maternity Care Partnership, in 2011, an uneventful hospital delivery, on average, in the United States cost between $10,657 (vaginal birth, no complications) and $23,923 (cesarean section birth with complications). The actual costs you pay, of course, vary depending on your health care coverage.
Baby Supplies and Equipment
Before you bring the baby home, you'll buy a crib, a changing table and a swing or bouncy seat. The moderately priced versions of these three things will cost you about $1,200. You'll also need at least one stroller that you can expect to pay about $400 for. A full-size infant car seat will cost you about $150-$200, and a full-size high chair will cost $150. Finally, you will spend several hundred dollars on washcloths, sheets, blankets, towels, undershirts, onesies, and other baby clothes. Also think about whether you plan to use a diaper service, cloth diapers, or use disposable ones.
Feeding and Diapers
The American Academy of Pediatrics recommends exclusively breastfeeding your baby for at least 6 months. Many women of course choose to breastfeed longer than that. Nursing mothers will have to invest in several good nursing bras and nursing pads (about $50) as well as a nursing pillow (about $25). If you plan to return to work after 3 months, consider investing in a hospital grade breast pump, which will run you about $400. In comparison, a year's worth of ready mix powder formula costs about $1,350. If you buy the ready-to-serve type of formula, the cost is even more running well over $2,000. You'll also need a year's supply of bottles, at about $90, and you'll have to add another $40 to replace the nipples at least twice in a year.
When your baby is ready for solid foods, you will also need to account for the cost of rice cereal and baby food.
Diapers are another expense you need to consider. Cloth diapers are the least expensive option. Disposable diaper costs for the first year run about $850, and a diaper genie costs about $40.
Child care expenses vary widely. Child care in a day care center costs much less than a live-in nanny (unless you have multiples, then a nanny or au pair is the less expensive option), and prices for day care centers vary widely. Child care in a day care center costs much less than a live-in nanny. A mid-priced day care center charges on average $975 per month for your infant's care, or close to $12,000 per year.
Your infant will visit the doctor about six times during his or her first year, including well-baby check-ups as well as the inevitable colds and fevers of infancy. How much you will spend for doctor visits during the first year depends on your health insurance.
Toys and Clothes
You will spend about $500-$600 on toys and clothing during the first year (in addition to what you bought for the layette.)
Total for the First Year
Your total expenses for the first year run about $15,000-$18,000. The biggest variable is the cost of health care.
During these years, you'll spend about $1,000 on toys and clothes, and about $2,200 a year on food. If your child attends day care or pre-school, add in the cost of these services. Day care will cost you an average of $12,000 per year, while pre-school costs vary widely. Again, health care costs depend on your health coverage.
This is the time when the overall expenses of child-rearing drop and families can save more. During these years, your child care expenses will drop drastically. Health care costs generally stabilize unless of course, your child begins orthodontia during this stage. Then, you'll have to pay more. You are likely to spend more than in the previous stage on clothing, toys, and entertainment, but your kids won't be demanding the high-ticket clothing and other items of adolescence. The bill for food will be just slightly more than what it was in the previous stage. On the negative side, now that your kids are in school, you'll want to pay for all those extras that middle class kids have: dancing and music lessons, sports participation, and so on. And, if you decide to send your kids to private school or to summer camp, these expenses will have to be added in.
During this stage, you can expect your child's food, clothing, and entertainment bill to greatly exceed what it was during the previous stage. For instance, food costs will increase as a result of growth spurts in your adolescent and clothing costs are likely to rise as well as your teen takes more of an interest in his or her appearance.
Once your teen starts driving, your auto insurance will go up. The extra cost could be anywhere from $300 to $1,000, depending on your state of residence and whether your child is a boy or girl. If you intend to buy your child a car, add this expense in as well.
Sweet-16 parties, bar and bat mitzvahs, orthodontia, SAT-preparation courses, music lessons, sports…these are just some of things you might be paying for during those years.
The best time to start instilling financial skills and values is when children are young. Start giving your kids an allowance once they reach school age. Let them participate in making the decision of how much their allowance should be.
Some parents may want to require kids to do household chores to earn the allowance. Or, parents might want to provide an allowance, but pay kids extra for the performance of tasks. This incentive plan is, of course, a matter of individual child-rearing philosophy, but it does get the message across that money does not grow on trees.
Give your kids control over their own money (their allowance and whatever monies you give them that are not earmarked for some particular purpose). You can make suggestions to them about what they should do with it-i.e., that they might spend half and save half-but allow them the final say on what happens to the money.
Let them see the consequences of both wise and foolish behavior with regard to money. A child who spends all of his money on the first day of the week is more likely to learn budgeting if he is not provided with extras to tide him over.
How much allowance to provide is a matter of parental discretion. Most parents provide about $7 per week to their elementary school children, and from $12 to $20 a week to kids in junior high.
Beyond the basics of budgeting and saving, you will want to get your child involved in saving and investing. The easiest way to do this is to have the child open his or her own passbook savings account.
If you want your child to get familiar with investing, there are various child-friendly mutual funds available. The mailings from the fund can be a source of education. Or you may want to get the child interested in individual stocks.
You may want to start a "matching" program with your kids to encourage saving. For instance, for every dollar that the child puts into a savings account or investment, you might match it with 50 cents.
If you want to get your kids involved with investing, it will usually have to be done through a custodial account. There are generally two types of widely used custodial accounts-one is set up under the Uniform Gifts to Minors Act, and the other under the Uniform Transfers to Minors Act. The type of custodial account available depends on which state you live in.
With a custodial account, the child is the owner, but the custodian (usually a parent) manages the property until the child reaches the age of majority under relevant state law-either 18 or 21. The custodian must follow certain rules concerning management of the property in the account. These rules are intended to ensure that the custodian does what is in the child's best interests.
IRAs for Kids
If your child has earned income-from a paper route or baby-sitting, for example, or from working in the family business he or she can contribute earnings to an IRA. The IRA can be an extremely effective investment for a child because of the IRA's tax-deferral feature and the length of time the money is left in the IRA. If $3,000 per year is contributed to the child's IRA for ten years and the money is left to grow until the child reaches age 65, the amount in the IRA could reach $600,000 or more, depending on the returns on the investment. In 2014, your child can contribute the lesser of his or her earned income for the year or $5,500, either to a traditional IRA or a tax-free Roth IRA. The contribution limits are the same for both types of accounts.
To replace the "lost" earnings, the parents can give $3,000 per year to the child (or the amount of earned income the child has, if less). The child may have to file tax returns.
The drawback of course is that, with some exceptions, the money cannot be withdrawn before age 59-1/2 without tax penalty.
Related Guide: For tax rules on IRA withdrawals for higher education, please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
Kids can learn to use automatic teller machine cards for their savings accounts. They can also start using credit cards at an early age-with parental counsel and involvement. They can learn the concepts of incurring and paying off debts both from credit card use and from small loans that parents make them.
It is important to familiarize kids with paying taxes as well. If children have to file tax returns-as they would with an IRA--allow them to participate in the process; this will get them used to the idea of yearly tax payments, and can also be an opportunity for learning about how governments are run with tax revenues.
Note: One side benefit of getting your kids involved in money management is that it may help to avoid the "math phobia" some kids experience in junior high school.
Tip: Professional guidance should be considered for a life event change as major as a marriage of divorce.
Source: Expenditures on Children By Families 2013, US Department of Agriculture Publication Number 1528-2013. Before-tax Income of $61,530 and $106,540 (Average = $82,790).
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The "Nanny Tax" Rules: What To Do If You Have Household Employees
If you have a household employee, you may need to pay state and federal employment taxes. Which forms do you need to file for your household employees? Is your maid, housekeeper, or babysitter covered by the rules? This Financial Guide provides the answers to these and other questions.
This Financial Guide will help you decide whether you have a "household employee," as defined by the IRS, and, if you do, whether you need to pay federal employment taxes. It explains the rules for determining, paying, and reporting Social Security tax, Medicare tax, federal unemployment tax, federal income tax withholding, and state unemployment tax for your household employee. It also explains what records you need to keep. In addition, it provides you with the information you need to find out whether you need to pay state unemployment tax for your household employee.
While many people disregard the need to pay taxes on household employees, they do so at the risk of stiff tax penalties. As you will see below, these rules are quite complex and professional tax guidance is highly recommended.
A basic familiarity with these rules will make it easier to work with your tax advisor, saving you time, reducing tax costs, and avoiding tax penalties and interest charges.
The "nanny tax" rules apply to you only if (1) you pay someone for household work and (2) that worker is your employee.
- A household employee is someone who does work in or around your home. Examples of household employees include baby sitters, nannies, health aides, private nurses, maids, caretakers, yard workers, and similar domestic workers.
- A household worker is your employee if you can control not only what work is done, but how it is done. If the worker is your employee, it does not matter whether the work is full time or part time, or that you hired the worker through an agency or from a list provided by an agency or association. It also does not matter whether you pay the worker on an hourly, daily, or weekly basis, or by the job.
On the other hand, if only the worker can control how the work is done, the worker is not your employee, but is self-employed. A self-employed worker usually provides his or her own tools and offers services to the general public in an independent business. If an agency provides the worker and controls what work is done and how it is done, the worker is not your employee.
Example: You pay Betty to babysit your child and do light housework four days a week in your home. Betty follows your specific instructions about household and child care duties. You provide the household equipment and supplies that Betty needs to do her work. Betty is your household employee.
Example: You pay John to care for your lawn. John also offers lawn care services to other homeowners in your neighborhood. He provides his own tools and supplies, and he hires and pays any helpers he needs. Neither John nor his helpers are your household employees.
It is unlawful for you to knowingly hire or continue to employ a person who cannot legally work in the United States.
When you hire a household employee to work for you on a regular basis, he or she must complete USCIS Form I-9 Employment Eligibility Verification. It is your responsibility to verify that the employee is either a U.S. citizen or an alien who can legally work and then complete the employer part of the form. Keep the completed form for your records. Do not return the form to the U.S. Citizenship and Immigration Services (USCIS).
Two copies of Form I-9 are contained in the UCIS Employer Handbook. Visit the USCIS website or call 800-767-1833 to order the handbook, additional copies of the form, or to get more information.
If you have a household employee, you may need to withhold and pay Social Security and Medicare taxes, or you may need to pay federal unemployment tax, or you may need to do both. To find out, read the table below.
Then you need to:
|Pay cash wages of $1,900 or more in 2014 to any one household employee.
Do not count wages you pay to:
|Withhold and pay Social Security and Medicare taxes.
(You can choose to pay the employee's share yourself and not withhold it.)
|Pay total cash wages of $1,000 or more in any calendar quarter of 2013 or 2014 to household employees.
Do not count wages you pay to:
|Pay federal unemployment tax.
Note: If neither of these two columns applies, then you do not need to pay any federal unemployment taxes. However, you may still need to pay state unemployment taxes.
You do not need to withhold federal income tax from your household employee's wages. But if your employee asks you to withhold it, you can choose to do so.
Tip: If your household employee cares for your dependent under the age of 13 or your spouse or dependent who is not capable of self-care, so that you can work, you may be able to take an income tax credit of up to 35% (or $1,050) of your expenses for each qualifying dependent. For two or more qualifying dependents, you can claim up to 35% (or $2,100). For higher income earners the credit percentage is reduced, but not below 20%, regardless of the amount of AGI. If you can take the credit, then you can include your share of the federal and state employment taxes you pay, as well as the employee's wages, in your qualifying expenses.
To find out whether you need to pay state unemployment tax for your household employee contact your state unemployment tax agency. You'll also need to determine whether you need to pay or collect other state employment taxes or carry workers' compensation insurance.
Note: If you do not need to pay Social Security, Medicare, or federal unemployment tax and do not choose to withhold federal income tax, the rest of this publication does not apply to you.
Note: As of January 1, 2013, the employee social security tax rate is 6.2%. The Medicare rate remains unchanged at 1.45%; however, beginning January 1, 2013, Additional Medicare Tax applies to an individual's Medicare wages that exceed a threshold amount based on the taxpayer's filing status. Employers are responsible for withholding the 0.9% Additional Medicare Tax on an individual's wages paid in excess of $200,000 in a calendar year. An employer is required to begin withholding Additional Medicare Tax in the pay period in which it pays wages in excess of $200,000 to an employee. There is no employer match for Additional Medicare Tax.
Both you and your household employee may owe social security and Medicare taxes. Your share is 7.65% (6.2% for social security tax and 1.45% for Medicare tax) of the employee's social security and Medicare wages. Your employee's share is 6.2% for social security tax and 1.45% for Medicare tax for wages below the Additional Medicare Tax threshold (see above).
You are responsible for payment of your employee's share of the taxes as well as your own. You can either withhold your employee's share from the employee's wages or pay it from your own funds.
Social Security and Medicare Wages
You figure Social Security and Medicare taxes on the Social Security and Medicare wages you pay your employee. If you pay your household employee cash wages of $1,900 or more in 2014, all cash wages you pay to that employee in 2014 (regardless of when the wages were earned) up to $117,000 are social security wages and all cash wages are Medicare wages. However, any non-cash wages (food, lodging, clothing, and other non-cash items) you pay do not count as social security and Medicare wages. If you pay the employee less than $1,900 in cash wages in 2014, none of the wages you pay the employee are Social Security and Medicare wages, and neither you nor your employee will owe Social Security or Medicare tax.
Wages Not Counted
Do not count wages you pay to any of the following individuals as Social Security and Medicare wages:
- Your spouse.
- Your child who is under age 21.
- Your parent.
- An employee who is under age 18 at any time during the year.
Note: However, you should count wages to your parent if both of the following apply: (a) your child lives with you and is either under age 18 or has a physical or mental condition that requires the personal care of an adult for at least 4 continuous weeks in a calendar quarter, and (b) you are divorced and have not remarried, or you are a widow or widower, or you are married to and living with a person whose physical or mental condition prevents him or her from caring for your child for at least 4 continuous weeks in a calendar quarter.
Note: However, you should count these wages to an employee under 18 if providing household services is the employee's principal occupation. If the employee is a student, providing household services is not considered to be his or her principal occupation.
Also, if your employee's Social Security and Medicare wages reach $117,000 in 2014, do not count any wages you pay that employee during the rest of the year as Social Security wages to figure Social Security tax. (But continue to count the employee's cash wages as Medicare wages to figure Medicare tax.)
You figure federal income tax withholding on both cash and non-cash wages (based on their value). However, do not count as wages any of the following items:
- Meals provided at your home for your convenience.
- Lodging provided at your home for your convenience and as a condition of employment.
- $130 a month in 2014 for transit passes that you give your employee or, in some cases, for cash reimbursement you make for the amount your employee pays to commute to your home by public transit. A transit pass includes any pass, token, fare card, voucher, or similar item entitling a person to ride on mass transit, such as a bus or train.
- Up to $250 a month in 2014 to reimburse your employee for the cost of parking at or near your home or at or near a location from which your employee commutes to your home.
Withholding the Employee's Share
You should withhold the employee's share of Social Security and Medicare taxes if you expect to pay your household employee Social Security and Medicare wages of $1,900 or more in 2014. However, if you prefer to pay the employee's share yourself; see "Not Withholding the Employee's Share" in the next section.
You may withhold the employee's share of the taxes even if you are not sure your employee's Social Security and Medicare wages will be $1,900 or more in 2014. If you withhold the taxes but then actually pay the employee less than $1,900 in Social Security and Medicare wages for the year, you should repay the employee.
You pay withheld taxes as part of your regular income tax obligation. You don't deposit them periodically-subject to an exception for business owners. See "Payment Options for Business Employers" below.
Withhold 7.65% (6.2% for Social Security tax and 1.45% for Medicare tax) from each payment of Social Security and Medicare wages. Wages exceeding the $200,000 (single filer) threshold amount are subject to the additional Medicare tax or 0.9%. Instead of paying this amount to your employee, you will pay it to the IRS 7.65% for your share of the taxes. Do not withhold any social security tax after your employee's social security wages for the year reach $117,000 (2014).
If you make an error by withholding too little, you should withhold additional taxes from a later payment. If you withhold too much, you should repay the employee.
Example: You hire a household employee (who is an unrelated individual over age 18) to care for your child and agree to pay cash wages of $100 every Friday. You expect to pay your employee $1,900 or more for the year. You should withhold $7.65 from each $100 wage payment and pay your employee the remaining $92.35. The $7.65 is the sum of $6.20 ($100 x 6.2%) for your employee's share of Social Security tax and $1.45 ($100 x 1.45%) for your employee's share of Medicare tax (for wages under $200,000 for single filers). You will pay $7.65 you withhold with $7.65 from your own funds when you pay the taxes.
Not Withholding the Employee's Share
If you prefer to pay your employee's Social Security and Medicare taxes from your own funds, you do not have to withhold them from your employee's wages. The Social Security and Medicare taxes you pay to cover your employee's share must be included in the employee's wages for income tax purposes. However, they are not counted as Social Security and Medicare wages or as federal unemployment (FUTA) wages.
Example: You hire a household employee (who is an unrelated individual over age 18) to care for your child and agree to pay cash wages of $100 every Friday. You expect to pay your employee $1,900 or more for the year. You decide to pay your employee's share of Social Security and Medicare taxes from your own funds. You pay your employee $100 every Friday without withholding any Social Security or Medicare taxes. For each wage payment you will pay $15.30 when you pay the taxes. This is $7.65 ($6.20 for Social Security tax plus $1.45 for Medicare tax) to cover your employee's share plus the $7.65 for your share. For income tax purposes, your employee's wages each payday are $107.65 ($100 plus the $7.65 that you will pay to cover your employee's share of Social Security and Medicare taxes).
The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. Like most employers, you may owe both the federal unemployment tax (the FUTA tax) and a state unemployment tax. Or, you may owe only the FUTA tax or only the state unemployment tax. To find out whether you will owe state unemployment tax, contact your state's unemployment tax agency. See the list of state unemployment agencies at the end of this Guide for the address.
The FUTA tax is 6.0% of your employee's FUTA wages. However, you may be able to take a credit of up to 5.4% against the FUTA tax, resulting in a net tax rate of 0.6%. Your credit for 2014 is limited unless you pay all the required contributions for 2014 to your state unemployment fund by April 15, 2015. The credit you can take for any contributions for 2014 that you pay after April 15, 2015, is limited to 90% of the credit that would have been allowable if the contributions were paid by April 15, 2015.
WARNING: Do not withhold the FUTA tax from your employee's wages. You must pay it from your own funds.
You figure the FUTA tax on the FUTA wages you pay. If you pay cash wages to all of your household employees totaling $1,000 or more in any calendar quarter of 2013 or 2014, the first $7,000 of cash wages you pay to each household employee in 2014 is FUTA wages. (A calendar quarter is January through March, April through June, July through September, or October through December.) If your employee's cash wages reach $7,000 during the year, do not figure the FUTA tax on any wages you pay that employee during the rest of the year. For a discussion of "cash wages," see the section on Social Security Wages, above.
If you pay less than $1,000 cash wages in each calendar quarter of 2014, but you had a household employee in 2013, the cash wages you pay in 2013 may still be FUTA wages. They are FUTA wages if the cash wages you paid to household employees in any calendar quarter of 2013 totaled $1,000 or more.
Do not count wages you pay to any of the following individuals as FUTA wages:
- Your spouse.
- Your child who is under age 21.
- Your parent.
Example: You hire a household employee (not related to you) on January 1, 2014, and agree to pay cash wages of $200 every Friday. During January, February, and March, you pay the employee cash wages of $2,600. Because you pay cash wages of $1,000 or more in a calendar quarter of 2014, the first $7,000 of cash wages you pay the employee (or any other employee) in 2013 or 2014 is FUTA wages. The FUTA wages you pay may also be subject to your state's unemployment tax.
During 2014, you pay your household employee cash wages of $10,400. You pay all the required contributions for 2014 to your state unemployment fund by April 15, 2015. Your FUTA tax for 2014 is $42 ($7,000 x 0.6%).
You are not required to withhold federal income tax from wages you pay a household employee. You should withhold federal income tax only if your household employee asks you to withhold it and you agree. The employee must give you a completed Form W-4, Employee's Withholding Allowance Certificate.
If you agree to withhold federal income tax, you are responsible for paying it to the IRS.
You figure federal income tax withholding on both cash and non-cash wages you pay. Measure wages you pay in any form other than cash by the value of the non-cash item.
Do not count as wages any of the following items:
- Meals provided at your home for your convenience.
- Lodging provided at your home for your convenience and as a condition of employment.
- Up to $130 a month in 2014 for bus or train tokens (passes) you give your employee, or for any cash reimbursement you make for the amount your employee pays to commute to your home by public transit.
- Up to $250 a month in 2014 for the value of parking you provide your employee at or near your home or at or near a location from which your employee commutes to your home.
Paying Tax without Withholding
Any income tax you pay for your employee without withholding it from the employee's wages must be included in the employee's wages for federal income tax purposes. It is also counted as Social Security and Medicare wages and as federal unemployment (FUTA) wages.
Certain workers can take the earned income tax credit (EIC) on their federal income tax return. This credit reduces their tax or allows them to receive a payment from the IRS if they do not owe tax. You may have to make advance payments of part of your household employee's EIC along with the employee's wages. You also may have to give your employee a notice about the EIC.
Notice about the EIC
The employee's copy (Copy B) of the IRS 2013 Form W-2, Wage and Tax Statement has a statement about the EIC on the back.
Tip: If you give your employee that copy by January 31, 2014 (as discussed under Form W-2), you do not have to give the employee any other notice about the EIC.
Otherwise, you must give your household employee a notice about the EIC only if you agree to withhold federal income tax from the employee's wages but the income tax withholding tables show that no tax should be withheld. Even if not required, you are encouraged to give the employee a notice about the EIC if his or her 2013 wages are less than the amount shown in the instructions to 2014 Form W-5.
If you do not give your employee Copy B of the IRS Form W-2, your notice about the EIC can be any of the following:
- A substitute Form W-2 with the same EIC information on the back of the employee's copy that is on Copy C of the IRS Form W-2,
- Notice 797, Possible Federal Tax Refund Due to the Earned Income Credit (EIC), or
- Your own written statement with the same wording as Notice 797.
If you give your employee a substitute Form W-2 on time which lacks the required EIC information, you must give notice about the 2014 EIC to the employee within one week of the date you gave him or her the substitute Form W-2. If Form W-2 is required, but not given on time, you must give the employee notice about 2014 EIC by January 31, 2015. If Form W-2 is not required, you must give your notice to the employee by February 2, 2015.
When you file your 2014 federal income tax return in 2015, attach Schedule H, Household Employment Taxes. Use this Schedule, discussed further below, to figure your household employment taxes. You will add the federal employment taxes on the wages you pay to your household employee in 2014, less any advance earned income credit payments you make to the employee, to your income tax. The amount you owe with your return is due to the IRS by April 15, 2015.
Tip: You can avoid owing tax with your return if you pay enough federal income tax before you file to cover the employment taxes for your household employee, as well as your income tax. If you are employed, you can ask your employer to withhold more federal income tax from your wages in 2014. If you get a pension or annuity, you can ask for more federal income tax withholding from your benefits. Or you can make estimated tax payments for 2014 to the IRS, or increase your payments if you already make them.
Asking for More Federal Income Tax Withholding
If you are employed and want more federal income tax withheld from your wages to cover the employment taxes for your household employee, give your employer a new Form W-4, Employee's Withholding Allowance Certificate. Complete it as before, but show the additional amount you want withheld from each paycheck on line 6.
If you get a pension or annuity and want more federal income tax withheld to cover the employment taxes for your household employee, give the payer a new Form W-4P, Withholding Certificate for Pension or Annuity Payments (or a similar form provided by the payer). Complete it as before, but show the additional amount you want withheld from each benefit payment on line 3.
Paying Estimated Tax
If you want to make estimated tax payments to cover the employment taxes for your household employee, get Form 1040-ES, Estimated Tax for Individuals. Use its payment vouchers to make your payments. You can pay all of the employment taxes at once or in installments. If you have already made estimated tax payments for 2014, you can increase your remaining payments to cover the employment taxes. Estimated tax payments for 2014 are ordinarily due April 15, June 16, September 15, 2014 and January 15, 2015.
Payment Option for Business Employers
If you own a business as a sole proprietor or your home is on a farm operated for profit, you can choose either of two ways to pay the 2014 federal employment taxes for your household employee. You can pay them with your federal income tax as described above, or you can include them with your federal employment tax deposits or other payments for your business or farm employees.
If you pay the employment taxes for your household employee with business or farm employment taxes, you must report them with those taxes on Form 941 or Form 943 and on Form 940 (or 940-EZ).
You must file certain forms to report your household employee's wages and the federal employment taxes for the employee if you pay the employee:
- Social Security and Medicare wages,
- FUTA wages, or
- Wages from which you withhold federal income tax.
The employment tax forms and instructions you need for 2014 will be sent to you automatically in January 2015 if you reported employment taxes for 2013 on Schedule H (Form 1040), Household Employment Taxes.
Employer Identification Number (EIN)
You must include your employer identification number (EIN) on the forms you file for your household employee. An EIN is a 9-digit number issued by the IRS--not the same as a Social Security number.
Tip: You ordinarily will have an EIN if you previously paid taxes for employees, either as a household employer or in a business you own as a sole proprietor, or if you have a Keogh Plan. If you already have an EIN, use that number. If you do not have an EIN, get Form SS-4, Application for Employer Identification Number. The instructions for Form SS-4 explain how you can get an EIN immediately by telephone or in about 4 weeks if you apply by mail.
A separate 2014 Form W-2, Wage and Tax Statement, must be filed for each household employee to whom you pay:
- Social Security and Medicare wages of $1,900 or more, or
- Wages from which you withhold federal income tax.
You must complete Form W-2 and give Copies B, C, and 2 to your employee by January 31, 2015. You must send Copy A of Form W-2 with Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration by February 28, 2015 (March 31, 2015, if you file your Form W-2 electronically).
Use Schedule H (Form 1040), Household Employment Taxes, to report the federal employment taxes for your household employee if you pay the employee:
- Social Security and Medicare wages of $1,900 or more in 2014,
- FUTA wages, or
- Wages from which you withhold federal income tax.
File Schedule H with your 2014 federal income tax return by April 15, 2015. If you get an extension to file your return, the extension will also apply to your Schedule H.
If you are not required to file a 2014 tax return, you must file Schedule H by itself. See the Schedule H instructions for details.
Business Employment Tax Returns
Do not use Schedule H (Form 1040) if you choose to pay the employment taxes for your household employee with business or farm employment taxes. Instead, include the Social Security, Medicare, and withheld federal income taxes for the employee on the Forms 941, Employer's Quarterly Federal Tax Return, that you file for your business or on the Form 943, Employer's Annual Tax Return for Agricultural Employees, that you file for your farm. Include the FUTA tax for the employee on your Form 940 (or 940-EZ), Employer's Annual Federal Unemployment (FUTA) Tax Return.
If you report the employment taxes for your household employee on Form 941 or Form 943, file Form W-2 for the employee with the Forms W-2 and Form W-3 for your business or farm employees.
Keep your copies of Schedule H or other employment tax forms you file and related Forms W-2, W-3, W-4, and W-5. You must also keep records to support the information you enter on the forms you file. If you are required to file Form W-2, you will need to keep a record of your employee's name, address, and Social Security number.
Wage and Tax Records
On each payday you should record the date and amounts of:
- Your employee's cash and non-cash wages,
- Any employee Social Security tax you withhold or agree to pay for your employee,
- Any employee Medicare tax you withhold or agree to pay for your employee,
- Any federal income tax you withhold,
- Any advance EIC payments you make, and
- Any state employment taxes you withhold.
Employee's Social Security Number
You must keep a record of your employee's name and Social Security number exactly as they appear on his or her Social Security card if you pay the employee:
- Social Security and Medicare wages, or
- Wages from which you withhold federal income tax.
You must ask for your employee's Social Security number no later than the first day on which you pay the wages. You may wish to ask for it when you hire your employee.
An employee who does not have a Social Security number must apply for one on Form SS-5, Application for a Social Security Card. An employee who has lost his or her Social Security card or whose name is not correctly shown on the card should apply for a new card. Employees may get Form SS-5 from any Social Security Administration office or by calling l-800-772-1213.
How Long To Keep Records
Keep your employment tax records for at least four years after the due date of the return on which you report the taxes or the date the taxes were paid, whichever is later.
Department of Industrial Relations
649 Monroe St.
Montgomery, AL 36131-0099
Employment Security Tax
Department of Labor and Workforce Development
PO Box 11509
Juneau, AK 99811-5509
Unemployment Tax - 911B
Department of Economic Security
PO Box 6028
Phoenix, AZ 85005-6028
Department of Workforce Services
PO Box 2981
Little Rock, AR 72203-2981
Account Services Group, MIC-90
PO Box 942880
Sacramento, CA 94280
Unemployment Insurance Operations
Department of Labor and Employment
PO Box 8789
Denver, CO 80201-8789
Connecticut Department of Labor
200 Folly Brook Blvd.
Wethersfield, CT 06109-1114
Division of Unemployment Insurance
Department of Labor
PO Box 9950
Wilmington, DE 19809-0950
District of Columbia
Department of Employment Services
Office of Unemployment Compensation Tax Division
609 H Street, NE, 3rd Floor
Washington, DC 20001-4347
Unemployment Compensation Services
Agency for Workforce Innovation
107 E. Madison Street MSC 229
Tallahassee, FL 32399-0180
Department of Labor
148 Andrew Young International Blvd., Suite 800
Atlanta, GA 30303
Department of Labor and Industrial Relations
830 Punchbowl Street, Rm. 437
Honolulu, HI 96813
Department of Employment
317 Main Street
Boise, ID 83735-0002
Department of Employment Security
33 South State Street
Chicago, IL 60603
Department of Workforce Development
10 North Senate Avenue
Room SE 106 Indianapolis, IN 46204-2277
1000 East Grand Avenue
Des Moines, IA 50319-0209
Department of Human Resources
401 SW Topeka Blvd.
Topeka, KS 66603-3182
Division for Employment Services
PO Box 948
Frankfort, KY 40602-0948
Louisiana Workforce Commission
PO Box 94094
Baton Rouge, LA 70804
Department of Labor
PO Box 259
Augusta, ME 04332-0259
Department of Labor, Licensing & Regulation
1100 North Eutaw Street
Baltimore, MD 21201-2201
Division of Employment and Training
19 Staniford Street
Boston, MA 02114-2589
Department of Labor & Economic Growth
3024 W. Grand Boulevard
Detroit, MI 48202-6024
Department of Employment & Economic Development
332 Minnesota Street
St. Paul, MN 55101-1351
Department of Employment Security
PO Box 1699
Jackson, MS 39215-1699
Division of Employment Security
PO Box 59
Jefferson City, MO 65104-0059
Unemployment Insurance Division
PO Box 6339
Helena, MT 59604-6339
Department of Labor
PO Box 94600
State House Station
Lincoln, NE 68509-4600
Department of Employment Training and Rehabilitation
500 East Third Street
Carson City, NV 89713-0030
Department of Employment Security
32 South Main Street
Concord, NH 03301-4857
Department of Labor & Workforce Development
P.O. Box 947
Trenton, NJ 08625-0947
Department of Workforce Solutions
PO Box 2281
Albuquerque, NM 87103-2281
Department of Labor
State Campus, Building 12
Albany, NY 1224-03390
Employment Security Commission
PO Box 26504
Raleigh, NC 27611-6504
Job Service of North Dakota
PO Box 5507
Bismarck, ND 58506-5507
Department of Job & Family Services
PO Box 182404
Columbus, OH 43218-2404
Employment Security Commission
PO Box 52003
Oklahoma City, OK 73152-2003
875 Union Street, NE
Salem, OR 97311-0030
Department of Labor and Industry
7th and Forster Street
Harrisburg, PA 17121-0001
Department of Labor and Human Resources
PO Box 1020
San Juan, PR 00919-1020
Division of Taxation
One Capitol Hill, Suite 36
Providence, RI 02908-5829
Employment Security Commission
PO Box 995
Columbia, SC 29202-0995
Department of Labor
PO Box 4730
Aberdeen, SD 57402-4730
Department of Labor and Workforce Development
220 French Landing Drive
Nashville, TN 37243-1002
PO Box 149037
Austin, TX 78714
Department of Workforce Services
PO Box 45288
Salt Lake City, UT 84145-0288
Department of Labor
PO Box 488
Montpelier, VT 05601-0488
Department of Labor
PO Box 302608
St. Thomas, VI 00803-2608
PO Box 1358
Richmond, VA 23218-1358
Employment Security Department
PO Box 9046
Olympia, WA 98507-9046
Bureau of Employment Programs
112 California Avenue
Charleston, WV 25305-0016
Department of Workforce Development
PO Box 7942
Madison, WI 53707-7942
Unemployment Tax Division
PO Box 2760
Casper, WY 82602-2760
You may need to do the following things when you have a household employee: When you hire a household employee:
- Find out if the person can legally work in the United States.
- Find out if you need to pay state taxes.
When you pay your household employee:
- Withhold Social Security and Medicare taxes.
- Withhold federal income tax.
- Make advance payments of the earned income credit.
- Decide how you will make tax payments.
- Keep records.
By January 31, 2015:
- Get an employer identification number, if needed.
- Give your employee Copies B, C, and 2 of Form W-2, Wage and Tax Statement.
By February 28, 2015:
- Send Copy A of Form W-2 to the Social Security Administration.
By April 15, 2015:
- File Schedule H (Form 1040), Household Employment Taxes, with your tax return.
Your Child's Education: How To Finance It
How can you properly fund your children's education without draining your current cash flow? What should you do if they are a few years away from college and your education fund won't be enough? How can you increase your chances of getting financial aid? What tax benefits might be available to you? This Financial Guide answers these questions.
With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes.
According to the College Board, the annual increase in inflation-adjusted average tuition and fees at public four-year colleges and universities has declined in each of the past five years, from 9.5% in 2009‑10 to 0.9% in 2013-14. Despite the decline, college is still expensive and proper planning can lessen the financial squeeze considerably--especially if you start when your child is young. It should also be noted that in 2012-13 the average amount of aid for a full-time undergraduate student was about $13,370.
Here are some guidelines--geared to parents whose children are no older than elementary school age--for funding your child's education.
Start Saving Early
We cannot emphasize enough that getting an early start is basic to funding your child's education. The earlier you start, the more you'll benefit from the compounding of interest.
Planning Aid: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, see the Financial Calculator:College Savings Calculator.
When should you start saving? This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.
Example: Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%). On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.
Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. You'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments after time.
Find Out How Much You'll Need To Save
How much will your child's education cost? It depends on whether your child attends a private or state school. In the 2013-2014 school year, the total expenses--tuition, fees, board, personal expenses, and books and supplies--for the average private college are about $40,917 per year and about $18,391 per year for the average public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can cost more than $55,000 per year, whereas the costs for a state school can be kept under $10,000 per year.
Planning Aid: Use College Search, a database of over 3,200 two-and four-year colleges, to find and select the best colleges for your child.
Don't forget to add the costs of graduate or professional school to the amount your child will need.
Planning Aid: If you're trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 7% per year. For the most recent increases, refer to 2013 Trends in College Pricing.
Choose Your Investments
As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different from those used if you start when your child is age 12.
The following are often recommended as investments suitable for education funds:
Series EE Bonds are extremely safe investments. For tax treatment of redemption proceeds used for college, please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
U.S. Government Bonds are also safe investments that offer a relatively higher return. If you use zero-coupon bonds for your child's education, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.
CDs are safe, but usually provide a lower return than the rate of inflation. The interest is taxable.
Municipal Bonds, if they are highly rated, can provide an acceptable return from the tax-free interest if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.
Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:
Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable-return equivalent. For example, if the return on municipal bonds is 5% and you are in the 30% tax bracket, the equivalent taxable return is 7.1% (5% divided by 70%).
Stocks contained in an appropriate mutual fund or portfolio can provide you with a higher yield at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.
Deferred Annuities provide you with tax deferral, but the yield may not be acceptable because of the relatively high cost of these investments. Further, amounts withdrawn before you reach age 59-1/2 may be subject to a 10% premature withdrawal penalty.
Related Financial Guide: For further information on investing in annuities, please see the Financial Guide: ANNUITIES: How They Work And When You Should Use Them.
If you have insufficient savings for your child's education when he or she is close to entering college, there are ways to generate additional funds both now and when your child is about to enter school:
You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.
- You (or your child) can apply for various types of student aid and education loans (discussed below and in Info Sources).
Related Financial Guide: For further information on Equity Loans, please see the Financial Guide: HOME EQUITY LOANS: How To Shop For The One That's Best For You.
Tip: Sources of student aid and education loans should be exhausted before other types of loans are used, since the former make better sense financially. In some cases, however, a home equity loan can be advantageous because of the deductibility of interest.
Here is a summary of the possible sources of financial aid. The types of aid and tax implications change frequently, so consult your financial advisor for specifics when you're approaching the time to seek financial aid.
Grants, the best type of financial aid because they do not have to be paid back, are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.
- Federal Pell Grant Program. Pell grants are need-based.
Tip: Don't assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as "in need" depends on the cost of the college and the size of the family.
- State education departments may make grants available. Inquiries should be made of the state agency. Employers may provide subsidies.
- Private organizations may provide scholarships. Inquiries should be made at schools.
- Most schools provide aid and scholarships, both needs-based and non-needs-based.
- Military scholarships are available to those who enlist in the Reserves, National Guard, or Reserve Officers Training Corps. Inquiries should be made at the branch of service.
Tip: Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.
Loans may be need-based, and others are not. Here is a summary of loans:
- Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. They are needs-based for subsidized loans; however an unsubsidized version is also available.
- Perkins loans are provided by the federal government and administered by schools. They are needs-based. Inquiries should be made at school aid offices.
- Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Inquiries should be made at college aid offices or by calling 800-333-4636.
- Schools themselves may provide student loans. Inquiries should be made at the school.
Work-Study Programs. This is a program that is federally funded and based on the family's financial need. The student works on-campus and receives partly subsidized pay. The receipt of work-study funds does not affect the level of "need" for purposes of need-based grants and loans.
To make a thorough investigation, you should fill out the financial aid application, which you can obtain from the school's financial aid office. You will have to provide tax returns. The amount you are determined to be eligible for depends on your income, the size of your family, the number of family members currently attending college, and your assets.
Related Financial Guide: For information on Equity Loans, please see the Financial Guide: HOME EQUITY LOANS: How To Shop For The One That's Best For You.
How To Increase The Amount Of Financial Aid
Here are some strategies that may increase the amount of aid for which your family is eligible:
- Try to avoid putting assets in your child's name. As a general rule, education funds should be kept in the parents' names, since investments in a child's name can impact negatively on aid eligibility. For example, the rules for determining financial aid decrease the amount of aid for which a child is eligible by 35% of assets the child owns and by 50% of the child's income.
Example: If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6% of your assets and from 22 to 47% of your income.
- Reduce your income. Income for financial aid purposes is generally determined based upon your previous year's income tax situation. Therefore, in the years immediately prior to and during college, try to reduce your taxable income. Some ways to do this include:
- Defer capital gains.
- Sell losing investments.
- Reduce the income from your business. If you are the owner of your own business, you may be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
- Avoid distributions from retirement plans or IRAs in these years.
- Pay your federal and state taxes during the year in the form of estimated payments rather than waiting until April 15 of the following year.
- Since a portion of discretionary assets is included in the family's expected contribution from income, reduce discretionary assets by paying off credit cards and other consumer loans.
- Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
Detail your financial hardships. If you have any financial hardships, let the deciding authorities know (via the statement of financial need) exactly what they are, if they are not clear on the application. The financial aid officer may be able to assist you in explaining hardships.
- Have your child become independent (if feasible). In this case, your income is not considered in determining how much aid your child will be eligible for. Students are considered independent if they:
- Are at least 24 years old by the end of the year for which they are applying for aid,
- Are veterans,
- Have dependents other than their spouse,
- Are wards of the court or both parents are deceased,
- Are graduate or professional students or
- Are married and are not claimed as dependents on their parents' returns.
As noted above, education funds should generally be kept in the parents' names because of financial-aid considerations. However, in specific cases, it may be better to keep the investments in your child's name since the tax rate on the income will be less than if they are held in your name. Professional advice should be sought in making this decision.
In the past, parents would invest in the child's name in order to shift income to the lower-bracket child. However, the addition of the "kiddie tax" mostly put an end to that strategy. Now, investment income over $2,000 for 2014 (same as 2013) of children under the age of 19 (or 24 if a full time student) is taxed at the parents' rate. (This threshold is indexed annually for inflation.) Once the child reaches age 19, however, all income is taxed at the child's rate. Of this $2,000, one-half probably won't be taxed due to the availability of the standard deduction while the other half would be taxed at the child's rate.
Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child's rate. If you decide to invest in your child's name, here are some tax strategies to consider:
- You can shift just enough assets to create $2,000 in taxable income to an under-19 child.
- You can buy U.S. Savings Bonds (in the child's name) scheduled to mature after your child reaches age 19.
- You can invest in equities that pay small dividends but have a lot of potential for appreciation. The income earned when your child is under the age of 19 will be minimal, and the growth in the stocks will occur over the long term.
- If you own a family business, you can employ your child in the business. Earned income is not subject to the "kiddie-tax," and is deductible by the business if the child is performing a legitimate function. Additionally, if your business is a sole proprietorship and your child is under the age of 19, then he or she will not pay social security taxes on the income.
Note: The Kiddie Tax does not apply if the earned income of a student over age 18 exceeds half of the child's living expenses. Living expenses include food, housing, clothing, medical, dental, education and other necessary costs of support. Students over 18 are considered independent from their parents if they provide more than 50% of their own support.
There are also a number of tax incentives that you might be able to take advantage of. Please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
Tip: Reporting the kiddie tax on the child's return using the required Form 8615 calls for showing the parents' taxable income. A parent reluctant to show that item to a teenager may instead report the child's investment income of the parent's return, on Form 8814. But this is not allowed, and the Form 8615 route must be followed, where the child has taxable earned income, as many teenagers would.
- U.S. Department of Education (for information on financial aid): 1-800-USA-LEARN (1-800-872-5327)
Life Insurance: How Much and What Kind To Buy
How much life insurance do you need? What type is appropriate? You should review your life insurance needs each time you have a major life event. Here is what you need to know to properly plan for your life insurance needs-to buy enough and to get the most for your money.
The prospect of planning for your family's life insurance needs may seem daunting. The array of confusing products available, coupled with the calculations needed to find the right amount of insurance, would put anyone off.
Yet the hard fact is that life insurance is an essential part of your family's financial well-being. The more you know about it before you go to your agent, the better your coverage will be. If you don't plan for your life insurance needs, the result could be a waste of thousands of dollars on inappropriate or ineffective life insurance or, worse, financial hardship due to not having enough insurance.
We've tried to make the process of buying life insurance easier and more informed by providing you with objective, unbiased information and a plan of action. This Financial Guide gives you some basic guidelines about whether and when you should purchase life insurance, and provides you with a system for determining how much you need. It also discusses the types of insurance available, their suitability for various situations, and how to comparison shop for a policy.
The purpose of life insurance is to provide a source of income, in case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest. However we won't go into these other purposes in this guide.
Related Guide: Please see the Financial Guide: ESTATE PLANNING: How To Get Started.
Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. (You might also need life insurance for estate planning or business succession planning purposes.) Here are some typical insurance situations along with typical insurance needs:
Situation 1. Families or single parents with young children or other dependents. The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts. If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap. If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse (child care, housekeeping, and bookkeeping). However, if funds are limited, insurance on the non-wage earner should be secondary to insurance on the life of the wage earner.
Situation 2. Adults with no children or other dependents. If your spouse could live comfortably without your income, then you will need less insurance than the people in situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse. If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.
Situation 3. Single adults with no dependents. You will need only enough insurance to cover burial expenses and debts, unless you want to use insurance for estate planning purposes.
Situation 4. Children. Children generally need only enough life insurance to pay burial expenses and medical debts. In some cases, a life insurance policy might be used as a long-term savings vehicle.
Situation 5. Retirees. There is less of a need for life insurance after retirement, unless it is to be used for other estate planning purposes. You may need to provide an income for the second spouse to die if your retirement assets are not large enough. Further, you will need some insurance to pay burial expenses, final medical costs, and debts.
Determining how much insurance to buy requires you to invest some time in calculating...
Your current annual household expenses
- Your assets, debts, and other sources of income.
We've provided a work sheet, which we will refer to in our discussion.
Tip: Find out how much insurance you need before considering which type of insurance to buy. Having enough is more important than having the right type. You should provide for your insurance needs immediately, although you can always switch to a more cost-effective or investment-oriented type of insurance later.
The ideal amount of coverage is the amount that would allow your dependents to invest the insurance proceeds after your death and maintain their desired standard of living without touching the principal. Although the old rule of thumb-to buy five, six or seven times your annual salary-may serve as a starting point, it is no substitute for making the calculations to find out how much you really need.
By using the worksheet and our explanations, you will be able to make a fairly good estimate of your insurance coverage needs. You will need to make some assumptions about your family's future. It's important to be as accurate as possible in filling out the worksheet, since an underestimation could lead to your being underinsured, and an overestimation will lead to money wasted on unnecessary coverage.
Here is a line-by-line discussion of how to prepare the worksheet.
Line 1: Calculate The "Annual Income Needed"
Line 1 of the worksheet, "Annual Income Needed," is the amount that your survivors would need to live comfortably. It is important not to underestimate this amount. If there are recurring expenses that your family incurs but that are not shown on the list below, do not neglect to include these.
To arrive at the "Annual Income Needed," find the following amounts paid monthly. Then multiply the figure you arrive at by 12 to arrive at an annual amount. Add the following amounts:
|Mortgage or rent, and other home-related expenses. Include your monthly mortgage payment, with insurance and real estate taxes, or the amount paid for rent. Also include the amounts you spend monthly on home repairs-e.g., plumbers, contractors, electricians, appliance repair-and on home improvements. Add to this the amounts spent monthly on furniture, appliances, linens, and other items bought for the home
|Heat, electricity, insurance (life, health, and liability) water, gas, trash collection, and other monthly bills
|Food, including other items bought at grocery stores or drug stores, such as toothpaste, and including restaurant bills
|Travel, including car payments, gas and oil, car repair, and car payments
|Child care or other dependent care
|Recreation, including travel, gifts, theater, cinema
|Multiply by 12 and enter amount in Line 1 of the worksheet (below)
Line 2: Subtract "Other Sources"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
Tip: To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Line 3: Determine The "Shortfall"
Line 3 represents the shortfall, i.e., the amount you need your insurance proceeds to replace. This is determined by subtracting the "Annual Income From Other Sources" amount from the "Annual Income Needed."
Line 4: Determine the "Amount Of Proceeds Needed"
Line 4 is the amount that will generate the investment income needed to make up the annual "Shortfall" in Line 3.
The amount by which you should divide line represents the after-tax rate of return you can expect on the invested life insurance proceeds. The amount you choose to divide by depends on how conservative you want to be. It is reasonable for most people to expect an after-tax rate of return of at least 6%. But if you want to ensure that you are protected from inflation risk and interest rate risk, use the lower divisor of 4%. The middle divisor of 5% represents a "middle of the road" approach.
The amount you arrive at is the amount of death benefit (proceeds) you will need. The amount will be further adjusted as you work through the worksheet.
Line 5: Add the "Lump-Sum Expenses"
These are the items your family will have to pay for at the time of death. They differ from the "annual income needs" amounts in that they are not part of the family's everyday living expenses. Further, unlike the annual income amounts, they represent pure guesswork. If you wish to strive for a higher rate of accuracy, you can try to adjust these items for inflation, but this is not strictly necessary.
The estimate for funeral expenses should be at least $5,000. Depending on your desires and those of your family, you can adjust this figure upward.
The final medical expenses will be minimal if you have adequate health insurance. You can estimate this amount by finding out how much your policy requires you to contribute per illness.
The estate administration and probate costs can be estimated at 5% of your estate for the sake of simplicity. Your estate is the total value of your assets at death.
You will only owe federal estate taxes if your taxable estate exceeds the amount of the unified credit exemption equivalent. Your state inheritance taxes will depend on the laws in your state.
The "emergency living expenses" amount can range from three to six months' worth of family living expenses.
The "debts" amount represents debts that your family desires to pay off at your death. Normally, it does not include items that make up the "annual living expenses"-e.g., mortgage payments, car payments. However, if you decide that you wish to use insurance proceeds to pay off such expenses, then add in the amounts you estimate will be needed to pay off such debts.
As for future education expenses, it is suggested that you use an annual cost of $20,000 per child, per year, for the sake of simplicity.
Line 6: Determine the "Interim Insurance Proceeds Amount"
Subtract the "future expenses" on line 5 from the "proceeds needed" amount on line 4. This is the amount of insurance you will need to buy on your life. The amount will be further adjusted.
Line 7: Subtract the "Assets That Can Be Sold and Other Insurance"
For line 7, determine the amounts that represent assets that your survivors could liquidate to pay future expenses. Do not include any assets your survivors will be using to produce income that you included in "other sources." Also, note that you should include insurance payments and pension death benefits here, and not on the line for "other sources." This is because such proceeds will represent one-time payments, and not sources of annual income.
Line 8: Determine the "Total Insurance Needed"
Subtract the "assets that can be sold and other insurance" on line 7 from the interim insurance proceeds amount" on line 6. This is an estimate of the amount of insurance coverage you need.
Life Insurance Worksheet
|1. Annual income needed.
|2. Subtract other annual income sources:
|Salary of surviving spouse and other family
Estimated earnings on investments
|Total other annual income sources
|3. Subtract total of line 2 items from line 1
|4. Amount of proceeds needed (divide line 3 by 4%, 5%, or 6%)
|5. Lump-sum expenses:
Final medical costs
Estate administration and probate costs
Federal estate and state inheritance tax
Emergency living expenses fund
Debts to be paid off
Other lump-sum expenses
Total lump-sum expenses:
|6. Interim insurance proceeds needed
(add line 4 and total of line 5 items)
|7. Assets that can be sold and other insurance
Employer-provided group life insurance
Other life insurance.
Death benefit from pension plan.
IRA, Keogh, and 401(K) plan lump sum amounts
Other assets that can be sold
|8. Total insurance needed (subtract total of line 7 items from line)
Term, whereby you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified; and
- Cash value, usually referred to as whole life, universal life, or permanent life insurance, where, in addition to paying a death benefit, it also provides you with some other redeemable value.
For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40. There are various types of term insurance, which we will discuss briefly here.
Renewable. Renewable term policy is the most common type of life insurance where the policy renews automatically on a renewable term, e.g. every year, every 5 years, every 10 years, or every 20 years--the most popular renewal term. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so.
- Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.
Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy. Nearly all life insurance bought today is level term.
Decreasing. With a decreasing term policy-a good option for insuring mortgage payments-the face amount of the policy decreases over time while the premium payments remain the same.
Return of Premium. Some insurers offer term life with "return of premium". Typically, premiums are significantly higher and they require keeping the policy in force to its term.
Cash Value Insurance
There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life and (4) variable whole life. The first two types are the most common and have a guaranteed cash surrender value; in the last two types, the cash surrender value is not guaranteed.
Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term, but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
Tip: You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies-are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders, while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies.
Note: Term policies can also be participating, but the dividends paid are usually minimal.
Universal Life. Universal life, also known as "flexible premium adjustable life," is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth. With a universal life policy, your monthly premium amount is first credited to your cash value. The company then deducts the cost of your death benefit and the expenses of the policy. These costs are about equal to what it would cost to buy term coverage. As with whole life, your cash value grows at a fixed minimum rate of interest. The growth of the cash value is tax-deferred, and you can borrow against it or make partial withdrawals.
Caution: A special feature of universal life is that you can vary the premium paid from month to month. You can pay more or less-within certain limits-without jeopardizing your coverage. You can even let the cash value absorb the premium. However, the danger here is that if the premium payments fall too low, your policy may lapse. While some states require the insurer to tell you when your cash value is at a dangerously low point, you will, if you live in another state, have to maintain a careful watch on the amount of cash value if premiums are skipped.
Variable Universal Life. Variable universal life allows you to choose the investment for your cash value. You have a potentially greater cash value growth, but you also have added risk, depending on the type of investment you choose.
Variable Whole Life. With variable whole life, the death benefit and cash value will depend on the performance of an investment fund that you choose. Again, you have potentially greater reward, with its accompanying risks.
Here, in table form, is a summary of the different features of the various types of life insurance.
|Variable Whole Life
|Variable Universal Life
|Stated in policy
|Until age 95
|Type of death benefit
|Variable and determined
|Existence of cash value
|Current rate, guaranteed minimum
|Fixed rate, guaranteed
|Variable rate, not guaranteed
|Variable rate, not guaranteed
|Ability to choose cash value investments
|Insurance and securities
|Insurance and securities
In order to be able to shop for the best premiums, it's a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.
Insurance companies place individuals into four risk groups: preferred, standard, substandard, or uninsurable. The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated insurers.
If you have a high risk job or hobby, you will be considered substandard, a high risk. A terminal illness at the time you apply for insurance will render you uninsurable. Having some type of chronic illness will place you in the substandard category. People with conditions such as diabetes or heart disease can be insured, but will pay higher premiums.
Tip: One company's category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you "substandard."
Tip: Once an insurance company approves you for coverage, you cannot be dropped unless you stop paying your premium.
In most states, there are rules, set by a group of state insurance regulators, requiring the agent to calculate two types of cost indexes that can help you to shop for a policy. You can use the indexes to compare policy costs.
One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number is the less expensive the policy will be. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.
These two indexes apply to term and whole life policies. With universal life policies, focus on the cash value growth and the cash surrender value to make comparisons. Cash surrender value is the amount you receive if you cancel the policy. It is not the same as cash accumulation value. If you are shown two universal life policies, and they have the same premium, death benefit, and interest rate, then the one with the higher cash surrender value is generally the better policy.
Here are some questions to ask about policies:
How do cash values accumulate? An early, rapid build-up is generally preferable.
How has the policy's cash value performed in the past? You can get this information from a publication called Best Review, Life and Health. Determine how the policy performed in comparison with the company's projection and with other insurers.
Are any special features merely bells and whistles, or do they add value for you?
- What is the company's rating with Best, Standard & Poor's, and Moody's? You can find these publications in public libraries. The rankings should be in the top three to ensure that a company has financial stability.
- National Insurance Consumer Helpline
1001 Pennsylvania Avenue NW
Washington, DC 20004
Phone: (800) 942-4242