Reflections

Give the Gift of a Roth IRA

This holiday season, for your child (or grandchild) who has everything, consider the gift of a Roth IRA.  Roth IRAs are a widely popular investment strategy and for good reason: qualified Roth IRA earnings are tax-free and there is no required minimum distribution (RMD), making these accounts a powerful tool for both retirement and estate planning. Investors pursuing Roth IRAs face two main obstacles, however: income limits and shorter time horizons. For married couples with an AGI above $203,000, Roth IRAs are disallowed.  Furthermore, investors in their prime working years may only have 10-15 years until retirement, diminishing the total number of years Roth contributions can compound tax-free.

Yet there is an excellent way for high-earning families to still take advantage of a Roth IRA.  What many may not know is that children can make Roth IRA contributions if they have compensation. And these contributions can come in the form of a gift.  So, if your 15 year-old daughter or granddaughter has earned $6,000 at a summer job, you can gift them up to $6,000 (the maximum annual contribution) to invest in a Roth IRA in their own name.

If your 15-year old child or grandchild has earned $6,000 at a summer job, you can gift them up to $6,000 (the maximum annual contribution) to invest in a Roth IRA in their own name.

Gifting a Roth IRA to a child is an outstanding way to introduce them to the concept of savings and investment.  Because you can only gift and contribute an amount equal to a child’s earned income for a given year, a Roth IRA gifting plan may even motivate them to work more or apply for that summer job. Most importantly, assuming children properly care for their Roth IRAs and do not make unqualified withdrawals, these accounts will become significant assets.

The Amazing Power of Compound Interest

Most investors understand the power of compound interest – the cycle of earning “interest on interest” which can cause wealth to rapidly snowball. To understand this deceptively simple concept, a visual cue may be helpful. Try using the chart to explain to your working (or soon to be working) child how by investing early they can reap huge rewards. The simple fact is that when you start saving outweighs how much you save.

3Q14-WG-IRA-Roth-Chart-2

Seen above, Alice, Barney and Christopher experience the exact same 7% annual investment return on their retirement funds.*  The only difference is when and how often they save:

  • Alice invests $5,000 per year beginning at age 18At age 28, she stops. She has invested for 10 years and $50,000 total.
  • Barney invests the same $5,000 but begins where Alice left off. He begins investing at age 28 and continues the annual $5,000 investment until he retires at age 58.  Barney has invested for 30 years and $150,000 total.
  • Christopher is our most diligent saver. He invests $5,000 per year beginning at age 18 and continues investing until retirement at age 58.  He has invested for 40 years and a total of $200,000.

A key takeaway here is Barney has invested 3 times as much as Alice, yet Alice’s account has a higher value. She saved for just 10 years while Barney saved for 30 years. Seen here, compound interest is the process where all of the investment return that Alice earned in her 10 early years of saving is snowballing. The effect is so drastic that Barney can’t catch up, even if he saves for an additional 20 years.

Of course, the best scenario here is Christopher, who begins saving early and never stops. Note how the amount he has saved is massively higher than either Alice or Barney. Is it so astounding that Christopher’s savings have grown so large?  Not necessarily – what is most remarkable is how simple his path to riches was. Slow and steady annual investments, and most importantly beginning at an early age. By gifting your child $6,000 to contribute to a Roth IRA during a few of their earliest working years, perhaps they can become devoted to the idea of letting their savings work for them.

The simple fact is that when you start saving outweighs how much you save.

Planning for Wealth Transfer

The Roth IRA can help families preserve and transferring wealth across generations. Because Roth IRAs do not have RMDs, these assets will not need to be systematically depleted before being passed on to heirs, increasing the benefit of tax-free growth. Gifting a contribution to a Roth IRA in a child’s name presents a new avenue for planning, especially if parents’ Roth IRA contributions are maxed (or AGI rises above phase-outs).  Let’s look at two options:

Contribute $6,000 to a child’s Roth IRA vs. investing the assets in a taxable account owned by the parents. Here investing in the parents’ name presents two downsides.  First, the size of the estate could grow, subjecting the assets to estate tax when transferred.  Second, when the child withdraws the funds after inheritance, they will be subject to capital gains tax (the child will receive a step-up in basis at inheritance).

Contribute $6,000 to a child’s Roth IRA vs. investing the assets in a parent’s Roth IRA. If wealth transfer is your only goal, contributing to the Roth IRA of a working child is a better option than contributing to your own Roth IRA. The reason is that while the original owner of a Roth IRA does not need to take RMDs, the beneficiary owner does. This means that when your child inherits your Roth IRA they will need to deplete the value of the inherited account during their lifetime. If you were to have invested an identical amount to a working child’s Roth IRA, these assets can continue to grow tax free through the next generation.

By gifting your child $6,000 to contribute to a Roth IRA during a few of their earliest working years, perhaps they can become devoted to the idea of letting their savings work for them.

Planning for Education

Roth IRAs can serve as an effective alternative (or supplement) to 529 savings plans. Roth IRA owners are allowed to take early withdrawals for payment of qualified higher education expenses without penalty. The exception eliminates the 10% early withdrawal penalty only, withdrawn earnings are still subject to income tax (withdrawn principal is tax-free). This rule makes it more effective to plan for education using a Roth IRA in a child’s name (at a lower tax-bracket) than in the parents’ name.

Roth IRAs benefit from the same primary advantage as 529 plans: tax-free growth of contributions. However, 529 plans stipulate inflexible investment options because investors must select from a limited pool of investment choices. The investment choices in a Roth IRA are practically unlimited. Roth IRAs are also excluded from Free Application for Federal Student Aid (FAFSA) whereas Section 529 plans are not. In the rare instance that you have saved too much for education, Roth IRA assets can grow tax-free long after education is paid for, while 529 plans can only be withdraw tax-free if used for education. Advantages to Section 529 plans include deductible contributions on some state tax returns and considerably higher contribution limits than Roth IRAs.

There is one considerable disadvantage to Roth IRAs vs. Section 529 Plans: the need to pay tax up-front on Roth IRA contributions (qualified Section 529 contributions are not taxed at investment nor withdrawal). However, gifted contributions to a working child’s Roth IRA may avoid this tax. Because most children earn little income and are not subject to federal income tax, it is likely that any Roth IRA contributions can be made tax-free.

Consider giving your child the gift of a Roth IRA this holiday season. Sure, it won’t light up their eyes as much as the gift they really asked for, but it can introduce them to the concept of savings and investment – a gift that will unmistakably keep on giving.

*A 7% annual return is hypothetical. Past performance is no guarantee of future results.  Data here is obtained from what are considered reliable sources as of 3/31/2019; however, its accuracy, completeness, or reliability cannot be guaranteed.

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