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Help Your Children Reach Financial Independence
By Philip A. Dyer
Fall 2005
Would you like to help your children accumulate more than $1 million in tax-free retirement assets with a relatively small investment?
You can do exactly that with a highly effective but often overlooked financial strategy: Open a Roth IRA for your child!
The Rules
A child can open an IRA (traditional or Roth) only if he or she has legitimate "earned income" through self-employment or W-2 wages. This money can come from typical jobs such as cutting grass, delivering newspapers, bagging groceries or working at a fast-food restaurant. A child that performs real work or duties in a family business - data entry, filing, cleaning the office - also qualifies. (It is a good idea to pay any children working for the family business periodically - say, monthly - by check and to keep a time sheet.)
A child, regardless of age, can use this income to fund an IRA subject to the lesser of $4,000 for 2005 (increasing to $5,000 in 2006) or 100 percent of earned income. As with all IRAs, you have until April 15 of the following year to put the money into the account.
Some children may be reluctant to turn over their hard-earned babysitting or lifeguarding money to mom and dad to fund an investment they won't be able to use for many years. Fortunately, parents and grandparents can give kids some or all of the IRA funding money as gifts, allowing the children to keep and/or spend what they make. Any money gifted in this manner must be aggregated with any other gifts and are subject to the $11,000 annual gift exclusion.
If the child is a minor, the account must be set up as a "custodial IRA" with the child's social security number on the account but an adult parent or guardian shown as the custodian. Once the child turns 18, the custodial feature may be removed.
The Benefits
How powerful is this savings tool? Let's look at two examples:
Example 1: Johnny, age 13, has a part-time paper route and earns $1,400 per year. His parents open a custodial Roth IRA for Johnny and fund it through gifts limited to the amount of his earned income each year. If Johnny keeps the paper route until age 18 (five years of funding), continues to earn $1,400 per year and never puts another dime into the Roth IRA, it will grow to $305,787 by the time he turns age 65 (assuming an eight percent average annual rate of return). Not bad for a total investment of only $7,000!
Example 2: Sarah, age 15, works for her mother, a real estate agent. She helps her mother with data entry and promotional flyers. Her mother can pay her what she would reasonably pay an outside employee for the same duties (say, $15 per hour). Sarah works 300 hours each year until age 18, earning $4,500 per year. Sarah contributes $2,000 to a custodial Roth IRA and her mother matches that with a $2,000 gift for a total of $4,000 per year. In four years, she will accumulate $18,024 in her Roth IRA (assuming an eight percent average annual rate of return). If Sarah continues to work for her mother through college (an additional four years) and make additional contributions, the account will grow to $42,546. If she stops and lets the money grow tax-free until age 65, she will have amassed $1,164,341. If she continues to contribute $4,000 per year after college until age 65, she will have a whopping $2,482,673 - all available tax-free!
The Caveats
First, remember that the money must come from legitimate earned income, so it will be difficult for a very young child to qualify unless he or she is a child actor or model.
Second, some financial institutions are unfamiliar with these rules and may be hesitant to open a custodial IRA or ask for verifiable W-2 income. If the bank, brokerage house or mutual fund company seems reluctant, ask to speak with a manager to resolve the issue. If they still refuse, take your business to another institution, since there are plenty that will help you.
Third, since the time frame is so long on this investment, use growth-oriented stock mutual funds for maximum long-term appreciation.
Roth IRAs for working children are an immensely powerful wealth-building tool and an excellent way to teach kids about money and investing. If your situation qualifies, open one today!
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© 2005, Military Officers Association of America (MOAA). Former Army captain Phil Dyer is a Certified Financial Planner and Deputy Director of Financial Planning at MOAA (www.moaa.org/financialcenter).
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Traditional vs. Roth IRA
Traditional IRA: Popular means of saving money for retirement. Depending on how much you earn, you may deduct your contribution from your taxable income. Taxable upon withdrawal after age 59 1/2. Penalties apply for early withdrawal.
Roth IRA: No tax break as you deposit money into the account, but tax-free upon withdrawal after age 59 1/2. Penalties apply, but with more exceptions than for a traditional IRA.
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