One of the simplest and most powerful ways to help children and grandchildren build financial security in their adult years is to fund a Roth IRA account for them. For many children including younger adults just beginning a career or starting a family, the help they receive from family members can be a pivotal factor in enabling them to fund a comfortable retirement.
Most people recognize the importance of using tax-advantaged accounts such as IRAs to provide for their own retirement, but few think of using these vehicles to transfer wealth to future generations. Not only can this strategy produce astonishing results due to the power of several decades of tax-free compounding growth, it can also set the stage for the child to begin his or her own sensible lifetime saving and investing program long after parents and grandparents have stopped contributing.
Compounding occurs when investment earnings themselves generate earnings creating a powerful snowball effect for building wealth. When regular contributions are made and allowed to grow over long periods of time without the drag of taxes (as with a Roth IRA), the results are astounding. Assuming average annual investment returns of 5 percent contributing just $5,000 per year for ten years between ages 16 and 26 in their IRA -and then never adding another dime- will result in an account balance of $465,000 at age 66. If at age 26, the person is able to continue contributing $5,000 per year until retiring at age 66, the amount will swell to $1.1 million. Furthermore because it is a Roth IRA all growth and withdrawals at retirement will be tax-free. Tax-free compounding of even modest contributions and earnings over 50 years inside a Roth IRA can produce substantial wealth.
The rules for establishing an IRA (traditional or Roth) for a young person are the same as those for an adult. There is no minimum age for investing in an IRA; however, the youngster must have legitimate earnings from work (e.g. summer job, part-time work, etc.) during the year. The IRA contribution cannot exceed the lesser of earned income or $5,500 for 2013. There are no rules stipulating that the child’s own money must go into the IRA allowing the source of the contribution to be a different person. In most cases the decision to go with a Roth instead of a traditional IRA is easy for two key reasons. First, the tax deduction on contributions that a traditional IRA offers provides little or no benefit for a young person with low earnings. Second, unlike a traditional IRA, which requires the account owner tol eventually pay taxes on any retirement withdrawals, Roth accounts grow tax-free and all distributions at retirement are also tax-free.
With the holidays approaching, it might make sense to consider offering a smart financial gift like funding for a Roth IRA for a young family member. This is an important decision, so before putting money into an IRA, do your homework to fully understand the specific rules that apply, along with the potential advantages and disadvantages (e.g. impact on college financial aid) this strategy may have for you and your family. Helping young family members get started with a regular saving and investing plan has many benefits. The biggest one may be the satisfaction you’ll get from seeing the positive impact that you’re making on their lives.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.