Some sources suggest that Albert Einstein once declared, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
Even if Einstein never said such a thing, earning interest on interest is one of the most powerful forces in investing. The younger an investor begins the journey, the more time they have to reap these rewards — yet the young and extra money don’t often coincide. Minors who have part-time jobs tend to make minimum wage.
But what if parents and grandparents replaced gift cards and questionable holiday sweaters with a gift that builds a future retirement foundation for their children and grandchildren?
Funding your kids Roth IRA as a gift
The Roth IRA is an investment vehicle that, when the rules are followed, can experience both accumulations and distributions tax-free. While there is no such thing as a “free lunch” per se, this might be as close as it gets.
What: The opening of a Roth IRA. Note that a parent or adult will need to open a custodial Roth IRA for a minor.
Who: Your employed children or grandchildren. They must be employed and earning income for you to contribute to their Roth IRA.
How: Funding a Roth IRA that is equal to or less than their earned income.
Why: To produce tax-free Roth IRA funds for their future.
Roth IRA compound interest
For example, let’s say a 16-year-old earns $3,000 over the course of the next three summers. Let’s also say that their parents or grandparents match that to contribute $3,000 into a custodial Roth IRA for those years. The total contributions would equal $9,000.
Assuming a 7% rate of return and monthly compounding, when this child or grandchild is 68, this eighth wonder of the world could produce approximately $300,000 in tax-free Roth IRA results.
As you might guess, this does require knowing the rules that govern the funding of a Roth IRA.
To gift or not to gift?
Are you able to fund a Roth IRA as a gift? For 2019, the annual gift exclusion is $15,000 per person, per year. In other words, a married couple could potentially gift anyone $30,000 this year without having to file a gift tax return.
Keep in mind, a gift is a gift. The money given as a gift should not contain any conditions. Is it possible that a 21-year-old might miss out on this opportunity by visiting the other seven wonders of the world with the account proceeds? Yes. If this is a concern, it is also possible to modify one’s will and trust-related documents. I am not suggesting, I am just saying.
Roth IRA rules FAQ:
1. Do you need earned income to contribute to a Roth IRA?
Yes. As mentioned above, the child whose Roth IRA you’re contributing to needs to have earned income such as wages, a salary, etc. For today, we are going to assume our 16-year-old receives a Form W-2 from an employer.
2. Do you have to file a tax return to contribute to a Roth IRA?
No, regular Roth IRA contributions do not have to be reported. An unmarried dependent student in 2019 would need to file a tax return if he or she had earned income over $12,200.
3. What is the maximum Roth IRA contribution?
For 2019, the maximum Roth IRA contribution is $6,000. However, my example is based on the 16-year-old earning $3,000 in income; this means that a maximum of $3,000 can be contributed.
4. What if the money were used other than for retirement?
Life happens. Contributions that go into a Roth IRA, regardless of age or reason, can be taken out tax and penalty free. Earnings, on the other hand, would be subject to income tax and a penalty of 10% if taken out prior to age 59.5, unless an exception applies.
Opening a Roth IRA
If you have any questions about opening up a Roth IRA for your child or grandchild, contact the advisors at Wipfli Financial.
You can also read further on Roth IRAs in our other IRA-focused blogs: