Is a Roth IRA Right for Your Kids?

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As a Weiss reader, I’m sure you’re aware of the advantages of a Roth IRA compared to a traditional IRA. The main benefit, of course, is that under current law, qualified Roth IRA distributions aren’t taxed, no matter how much income is reported on the owner’s tax return.Roth IRA

What you may not know is that anyone with earned income can have a Roth IRA—even a child. And if you think that getting tax-free withdrawals is a good deal—then doing it for your kids is the very best deal!

Here’s why: The government won’t share in the magical effects of compounding.

 The earlier you start investing, the more benefit you will receive from the effects of compounding. Over very long periods, the results are overwhelming.

But what can a child do to earn money?

You might consider hiring your children (or grandchildren) to do work around the house. If you run a business or professional practice, it’s even better. You’ll be able to cut your taxes by hiring your child.

The premise is simple. Money you pay the youngsters reduces your business income—and your income taxes. The children will owe little or no tax, which you can pay for him or her, while fully funding their Roth IRAs

The younger the child is, the better. You’ll not only cut your own taxes today, but it is more than likely that the child will end up with a multi-million-dollar retirement fund, decades from now.

Here’s how the miracle of compounding creates a multi-million-dollar portfolio:

child-financial-planning Suppose that you hire your child. If he or she earns at least $5,500 a year, that much could be invested in the child’s Roth IRA. (You could pay a bit more in order to cover any payroll taxes). Let’s say that your child works for your business for 10 years. At $5,500 a year, he or she would have contributed $55,000.

How much that investment would be worth at the end of those 10 years depends on the rate of return during that period. To get an idea, we built models to calculate returns of 6%, 8%, and 10%.

Are these returns realistic? Morningstar’s Ibbotson subsidiary tracks investment returns going back to 1926. Through 2013, large-company stocks returned 10.1% a year. Shorter duration’s could be much lower or much higher. Our illustrations are assuming that we are going to be invested for the very long term.

First, in order to find the value after 10 years, we figured that based on a 6% return, the $55,000 total invested would be worth $74,669, based on an 8% return, it would be worth $82,863, and based on a 10% return, it would be worth $92,039. Keep in mind that the full $55,000 was invested for only half the time, on average. (In the first year only $5,500 was invested and in the second, only $11,000, etc., therefore on average only $27,500 was invested for the full ten-year period.)

But the real effect of compounding is only just beginning! Those first years are just to get the wheels rolling.

Let’s assume that after 10 years, the child is now 15 years of age. And let’s assume a conservative 8% average annual return inside the Roth IRA, doubling every nine years (using the Rule of 72). That initial $55,000 invested over the first 10 years would be worth about $3,831,415 after 50 years. And if the average annual return were to be 10% per year, that figure would be $10,749,493. Now you see the magical power of compounding!

Again, how reasonable are these calculations?  Even during the past 10 years, which included “the Great Recession,” the S&P 500 returned an annualized 7.98% and, over the past five years, an annualized 12.79%.

As you can see, market returns vary from year to year, but over very extended periods, the broad averages seem to average out to be around 10% or better. If you can allow investments to compound over such long periods of time at such average annual returns you will have amazing results!

Keep in mind that the multi-million-dollar portfolio we calculated was achieved without any further investments after the first 10-year period. And if your child were able to continue to fund his or her Roth IRA account, the tax-free Roth IRA buildup is likely to be even more overwhelming.

 Still, many assumptions underlie those accumulations. To begin with, what kind of work can a young child do to earn $5,500 or more? The IRS might be skeptical.roth IRA

The answer is: Lots of things. There’s no reason why you can’t hire your child to do work around your house and lawn or work around your office.

If you run your own business, chances are that your business has a website and produces various promotional brochures. If a family theme fits in, you can use young children as models and pay them the going rate. Such pictures on your website or promotional brochures can help illustrate the benefits of your business to potential customers. Models earn a lot of money!

As your children grow older, the range of possible employment opportunities will expand, inside and out of the office. Besides the tasks that first come to mind (filing, cleaning, grounds keeping), your teenager (or pre-teen!) might help you establish a social media presence or do market research among peers.

When the child is off to college, you might buy a house near campus so your live-away collegian can avoid dorm fees while earning a management fee if you rent rooms to other students.

There are tax advantages for the whole family:

As mentioned earlier, hiring your child or grandchild can have immediate tax advantages for your family. Say you have an effective 35% marginal tax rate and you pay your child $5,500 a year. You save $1,925 a year: 35% times $5,500.

There are other tax advantages for hiring your children. For instance, wages paid to a child under age 18 who works for his or her parent’s trade or business are not subject to Social Security and Medicare taxes, as long as the entity is a sole proprietorship or a partnership between the child’s parents. In addition, wages paid to a child under age 21 who works at a parent’s trade or business are not subject to federal unemployment tax.

financial-planning-for-child-with-special-needs_qpvm4xCourt cases have upheld deductions for wages paid to very young children, provided the parents could show they were paid fair compensation. And hiring your children can deliver more than tax savings for you and substantial long-term wealth for your child.

At an early age, your youngsters can get an idea of what it means to work for money. They can learn values such as being on time, cooperating with other employees, and taking pride in accomplishing the tasks that they’ve been asked to perform.

Such beyond-school education might be largely lost on your five-year-old, but it won’t be long before your children are getting more from the entire exercise than just a Roth IRA.

Indeed, at some point you can begin to discuss investing with your child. It will be his or her retirement fund, so your child should have some idea of how the money is being invested and why. Helping your children to become intelligent investors can be at least as worthwhile as the money you’ll ultimately spend to send them to college!

That brings me to another important consideration: Unlike assets held directly in his or her name, assets held in a retirement account will not affect your child’s ability to obtain financial assistance to pay for college (even though some withdrawals from a Roth IRA can be made without penalty to pay for secondary education).

Instead of establishing a Roth IRA, which must be invested through a mutual fund or some other financial institution, you can follow the same process by using No-Fee DRIPs. The effect of compounding will be the same, but the dividends thrown off by the companies will be taxable annually at the child’s rate and eventually the gains will be taxed—though at the favorable capital gains rates.

Until Next Time,

Vita Nelson

Ms. Vita Nelson is one of the earliest proponents of Dividend Reinvestment Plans (DRIPs) and a knowledgeable authority on the operations of these plans. She provides financial information centered around DRIP investing. She is the Editor and Publisher of Moneypaper’s Guide to Direct Investment Plans, Chairman of the Board of Temper of the Times Investor Service, Inc. (a DRIP enrollment service), and co-manager of the MP 63 Fund (DRIPX).