Though I’ve yet to see my first Rockin’ Santa, I know the holiday season is upon us…if only because Walmart tells me so. Here’s a different gift strategy for that child or grandchild in your life—the gift of starting a nest egg.
There are tons of ways to get a youngster started on that savings front, but three are especially worth noting: the Roth IRA, a 529 college savings plan, and gifting appreciated stock. This blog is about the Roth IRA.
First, this is the biggest no-brainer out there when you have kids—and you, they or anyone else has the financial ability to give them an early boost by placing funds in a Roth IRA equal to the amount of money that the kid has earned. So, you have an eight-year-old who walks dogs or mows lawns (do kids still sell seeds?)—or designs websites, what do I know?—and makes a few bucks here and there. Junior doesn’t need a W-2, just a record of the income being earned.
Kids get a little taste of savings, responsibility, investing, inverted yield curves…well, that may be a stretch but you get the point.
To review, a Roth IRA is the obverse of the traditional IRA—the traditional IRA generally allows contributions to be made before state and federal taxes are paid; taxes are collected when the contributions and earnings are withdrawn later in life.
In contrast, the Roth IRA has no immediate tax benefits because contributions are not tax deductible. However, the Roth IRA allows for all funds, both contributions and future earnings, to be withdrawn completely free of federal taxes.
Basic rules—there is no minimum age, you gotta earn money and have records, and junior is not required to file income taxes to make a contribution (other than a simple Form 8606). You generally need to be 59 ½ to withdraw funds without penalty—as long as the account has been maintained for five years.
Parents and grandparents can do this on behalf of the kid as long as the kid earned some money. In other words, the exact dollar earned doesn’t have to be the dollar contributed to the Roth IRA. If your child makes a few thousand dollars, let them spend it on candy or clothes if that’s what you want to do, and make the contribution to their Roth on their behalf.
We all know the old maxim that the two most powerful words in the English language are “compound interest.” A $5,000 contribution put in for a ten-year old, growing at an average rate of 7% a year, would be worth a cool $232,000 at age 65. Put in $5,000 a year for five years and then leave it alone? How about a balance of $942,000? And yes, that’s 100% tax free.
The usual caveat here, folks: I’m a CFP®, not a doctor, dammit. And I’m not a CPA either, so consult a tax advisor.