A recent no load mutual fund study suggests that newly employed workers should contribute between 15% and 17% of their earnings to a retirement plan each year. This upward revision was due to in part uncertainty regarding future social security payments for workers entering the work force.
The advice is good. Dollars saved early in one's working career are many times more valuable than dollars saved in later life due to the magic of compound interest.
The Problem with Retirement Savings for Younger People
The problem, of course, is that young workers may have school debt as well as a mortgage to pay. If childcare expenses are added to the mix, retirement savings, especially at the suggested level, are often virtually impossible.
While more can be saved later in life, the compounding cannot be duplicated. Moreover, there is no ability to "catch up" on missed annual 401(k) or IRA windows which expire each year if they are not used. What can be done? Enter the $14,000 (or smaller) annual exclusion gifts which a grandparent or an parent may wish to make to reduce their estate taxes, or simply because they wish to help out the donee.
Yes, there is merit to repaying school debt and paying off a mortgage early, but each year an annual 401(k) or IRA contribution is missed an irremedial loss occurs. So instead of simply writing a check to a child, why not write two: one to the child for general assistance and a second in the amount of $5,500 for deposit into a newly established Roth IRA account as seed money for a growing retirement fund.
Roth IRA Requirements
There are a few requirements that must be met before a Roth IRA account can be opened for a child:
- The child must open the account (while you cannot open the account yourself, you can be authorized to get statements)
- The child (or the child's spouse) must have earned income (wages or self-employed income)
- The child's income if single must be less than $114,000, or if married the combined income must be less than $181,000 (income levels are for the 2014 tax year and are inflation adjusted each year)
Advantages of the Roth IRA Account
Roth IRA accounts have a number of unique advantages:
- Income earned on Roth IRAs is income tax-free if taken after the age of 59 1/2, or due to death or disability
- Income earned is sheltered from income tax during the accumulation period, i.e., from date of deposit until withdrawn, and then hopefully tax-free
If the child has income in excess of the Roth eligibility limits or if you wish to give more than $5,500 and shelter it for retirement purposes, ask the child to elect to defer income into his or her own 401(k) plan and then have them use your gift to pay for the expenses which otherwise prevent the contribution to the retirement plan. Ask to see an annual 401(k) statement showing the contribution each year.
Yes, the child could withdraw the Roth IRA contribution and earnings before the age of 59 1/2, but if that occurred and you disapprove, then there would be no future IRA contributions. Most children come to understand targeted gifts quite readily and this is seldom a problem.
It is sad to say that most struggling young parents lack the ability to adequately save for retirement. Yet it is precisely at this time that the contributions are most valuable.
What a Difference a Roth IRA Can Make
As an example of the power of tax-free compounding, consider this. Suppose a contribution of $5,500 per year is made to a Roth IRA for ten years between the ages of 23 and 32. Suppose further that these contributions will compound at an average net investment rate of six percent per year. At age 67, which is the current social security retirement age for someone born after 1960, the Roth IRA balance would be $590,630.
Source: Robert W. Baird & Co.
With the Roth IRA strategy, there are no complex trusts, no separate tax returns and minimal administration expenses. Can you think of a better gift than that?