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Estate Planning Strategy: Roth IRAs For Youngsters

Last update on: Aug 05 2021
estate planning

A Roth IRA is one of the best investment and wealth building vehicles for youngsters. That’s right, for youngsters. Establishing a Roth IRA within you restate planning for your children or grandchildren creates a valuable, low-cost legacy for which the youngsters later will be very grateful. A few thousand dollars will not likelly affect your estate planning now but could be worth hundreds of thousands of tax free dollars in the future.

The Roth IRA has many estate planning advantages. Investment earnings compound tax free. Distributions that occur at least five years after the initial contribution are tax free if made under any of these circumstances: after the owner is age 59 1/2; after the owner’s death; after the owner becomes disabled; or to pay for first-time homebuyers expenses up to $10,000 of the owner or family members. (Other distributions before age 59 1/2 are taxed and subject to a 10% penalty.)

Withdrawals of contributions are tax free, and contributions are assumed to be withdrawn first. That means after the earnings have compounded to a nice sum, the youngster can take the contributions tax free without touching the accumulated earnings.

Unlike regular IRAs, there are no required minimum distributions after age 70 1/2. There are required minimum distributions only after a Roth IRA is inherited.

There are no deductions or other benefits for contributions to a Roth IRA. The youngster, however, is unlikely to owe income taxes on the earned income and probably won’t even have to file a tax return.

Contributions are limited to $3,000 in 2002 and 2003 and will grow to $5,000 in 2008. Roth IRA contributions are not allowed if the owner’s adjusted gross income is above $110,000 for single taxpayers and $160,000 for married taxpayers filing jointly. (These amounts are adjusted for inflation each year.)

Roth IRAs for minors are especially attractive because a minor can take advantage of the investor’s best friend: time. A small investment will compound to a significant sum after a few decades.

Roth IRA contributions also are limited to the amount of the owner’s earned income for the year. Earned income is money earned from employment or self-employment.

Suppose Max Profits has a grandson, Hi, age 14. Hi earns about $2,000 mowing lawns, shoveling snow, or working at a local business. Hi, of course, spends his earnings on movies, CDs, computer games, and the occasional book. Max gives Hi $2,000 which is put into a Roth IRA for Hi. Max does this for four years, for a total of $8,000 in contributions.

The graph shows what happens to that Roth IRA if it earns 8% annually. By the time Hi is 20, the Roth is worth $15,689. At age 30 it is worth over $33,000. If Hi doesn’t take any distributions before 60, the Roth IRA will be worth over $340,000. That’s a good start to a retirement fund. It cost Hi nothing and cost Max only $8,000 over four years.

Opening a Roth IRA also is a good way to teach a youngster about money and investing. Have the youngster help set up the Roth IRA. Then, review the account statement together at least once a year to show how the account is doing and perhaps give a brief explanation of how it is invested.

When the child is a minor, the Roth IRA has to be opened as a custodial account. After the youngster turns 18 or 21 (depending on the state), he or she gets full ownership of the account. Money can be withdrawn and spent, and the youngster will be responsible for investing the account. Most of the major financial services firms accept Roth IRAs for minors.

A Roth IRA can be opened with less than the $3,000 maximum contribution. The minimum investment depends on the firm at which the IRA is opened. Strong Financial (800-368-3863) requires a minimum of only $250.

It is a good idea to keep records of the earnings in case the IRS decides to challenge the validity of the Roth IRA down the road. A W-2 issued by an independent employer is best. If the money is earned by working around the house or in the family business, keep a brief explanation of the exact work performed, when it was done, and the rate of pay. The pay must be reasonable for the work done and for the individual’s ability.

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