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.”
After trying to verify this quote, I asked a simple question: does it matter if he did or did not say this? No. What does matter? The power of math matters. Fear not the charts below, because in the math world they are fun!
My premise revolves around the power of investing early. What if parents and grandparents replaced gift cards with a gift that serves as a future retirement foundation for their children and grandchildren?
Giving Roth IRAs as Gifts
Is there an investment vehicle that, when the rules are followed, could experience both accumulations and distributions tax-free? Yes, there is. That investment vehicle is a Roth IRA. There is no such thing as a free lunch per se; however, this might be as close as it gets:
What: The opening of a Roth IRA.
Who: Our employed teenage children or grandchildren.
How: By funding a Roth IRA that is equal to or less than earned income.
When and Why: Why wait when you see the chart below. (click to enlarge)
The charts show how $3,000 contributed each year at ages 16, 17, and 18 can grow over the course of 50 years. Assuming an 8% annual rate of return, fast-forward to when your child or grandchild turns 66, and the eighth wonder at work has produced six-figure, tax-free Roth IRA results.
As one might surmise, this does require knowing the rules that govern the funding of a Roth IRA.
To Gift or Not To Gift?
Am I able to give a Roth IRA as a gift? Maybe. For 2014 the annual gift exclusion is $14,000 per person, per year. In other words, a married couple could potentially gift anyone $28,000 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 an 18-year-old might miss out on the eighth wonder by visiting the other seven wonders with the account proceeds? Yes, but it is also possible to modify one’s will and trust-related documents. I am not suggesting, I am just saying…
Three Roth IRA questions to ask:
1. Do you need earned income to contribute to a Roth IRA?
Yes, you need to have earned income such as wages, salaries, etc. For today, we are going to assume our 16-year-old receives a Form W-2 from an employer.
2. Do I 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 2013 would need to file a tax return if he or she had earned income over $6,100.
3. What is the maximum Roth IRA contribution?
For 2014, the maximum Roth IRA contribution is $5,500. However, my example is based on $3,000 of earned income; this means, using this example, a maximum of $3,000 can be contributed.
As a parent or grandparent, you have a powerful opportunity to provide a head start for your children and grandchildren toward their retirement.