Here is a power-packed way to help your grandchildren or children this summer. It gives them a financial incentive to work, but it also is a long-term incentive that will show them the value of saving and investing. Plus, you will provide them the core of a nest egg with Roth IRAs.
The strategy is to make a gift matching all or a portion of the youngster’s earnings, but match them by contributing to a Roth IRA for the child. The Roth IRA is perhaps the most powerful investment tax shelter available. It has “back-loaded benefits.” There is no deduction for contributions. But earnings of the account compound tax free. In the future, qualified distributions from roth iras are tax free.
Your contribution to IRAs is a gift, but it qualifies for the annual exclusion (up to $13,000 per donee; $26,000 if a married couple gives jointly). The contributions to the Roth IRA for the year can total a maximum of $5,000 or the youngster’s earned income for the year, whichever is lower.
The youngster won’t be able to take tax free distributions of earnings until age 59½. But distributions of contributions can be taken tax-free at any time.
The gift of Roth IRAs creates several attractive options for the child or grandchild.
The contributions and earnings can compound until the youngster needs to pay for college or a down payment for a first home. To the extent the amount withdrawn does not exceed contributions it is tax free but is subject to the 10% early distribution penalty. Accumulated earnings if withdrawn would be subject to income taxes and the 10% early distribution penalty. Additional earnings remain in the IRA to compound until they can be withdrawn tax-free at age 59½ or later.
Or the account can be left to compound until the youngster is at least age 59½. Then it can be used for retirement or whatever needs the loved one has at the time. You can do the computations to estimate what the account will total over time, using your own estimated investment return. But even at a modest rate of return, if the child is a teenager today when he or she is ready for retirement the Roth IRA will have compounded to more than 20 times your contributions. And the entire amount will be tax free to the youngster, unless the tax law changes.
The Roth IRA is a gift that keeps on giving, and it teaches a young person valuable lessons, including to focus on the long-term instead of the short-term.
August 2009. RW