How to save for your child's retirement
If you help Junior save early, you'll make his life as a senior so much better
There's a common motivator that makes parents feel like they're on a mission to make and save as much money as they can: We all want our kids to have the best life possible. That includes providing them a secure home, a good education, and maybe being able to offer a helping financial hand in crucial moments, especially when they're just starting out on their own.
But one thing that is out of reach for many of us, even if we make all the right decisions during our peak earning years, is saving enough to leave behind an inheritance the kids will be able draw on even after we're gone. There is, however, a pretty simple and nearly foolproof alternative for reaching the same goal: Open an IRA for your child while he or she is still a teen, and you could be building the foundation for them to have a comfortable retirement. You might even be making them rich.
You can set up an IRA for a child as long as he or she has earned income — that is, money he or she made doing some kind of job on the weekend, during a vacation, or after school. They can't fund it with their allowance. But if your kid made money bagging groceries, cutting lawns, babysitting, or working at a store on Main Street, it's okay to put every cent of those earnings — up to $5,000 — into a retirement account.
Even relatively small contributions made now really can become huge by the time your teen reaches retirement age, especially if your 15-year-old manages to wait until 70 or older to start making withdrawals. For example, if you can manage to put $8,000 into a Roth IRA for a kid by age 18, he or she will have $510,473 by age 72, assuming an 8 percent annual return.
The same money placed into a taxable investment account would grow to $186,040 — still a nice stash! — but nothing like the windfall from a Roth IRA.
The Roth part is key. For a mid-career adult, the choice between the two kinds of IRAs — traditional, in which contributions are tax-deductible but later withdrawals are taxed, and Roth, which have no tax breaks for contributions but allow later withdrawals to be tax-free — is a tough one. Reducing your taxable income by contributing to a traditional IRA is a great way to cut your tax bill and free up the extra money for things you need right now. A Roth's payoff comes in the form of tax-free income once you've reached your golden years, but it takes discipline to delay the benefit if retirement is still a long way off. For a young person making just a few thousand dollars with a part-time summer job, the choice is clear.
"A Roth IRA is a slam dunk for your child," says Carla Fried at CBS Moneywatch. "If they are very young with limited income they would garner no value from the deductibility of a traditional IRA contribution right now. The ability to make tax-free withdrawals from the Roth IRA a few decades down the line is going to be a huge gift, given the likelihood that taxes are likely to be heading up, not down, as the nation grapples with a massive deficit." In other words, says William Baldwin at Forbes: "For him, the upfront deduction is worthless. He’s probably in a 0 percent income tax bracket." But with a Roth, "at the retirement end, the account, by then much, much bigger, will be scot-free."
What's more, notes Fried: "Parents who keep up those Roth IRA contributions for a few years are likely to be raising a millionaire." In fact, assuming those 8 percent annual returns, your child will have almost exactly $1 million in a Roth IRA if it has $25,000 in it by the time he or she is 24 years old — even if nobody contributes another dime.
As a tax strategy, this is certainly a winner. But if you're going to try to fund the IRA with as much as possible, up to your child's total earnings if they don't earn enough to make a maximum contribution, you probably don't want to ask them to fork over all of their earnings (if you do, good luck with that). So you might try matching what they contribute, or simply covering the contribution entirely. "Remember," says Fried, "the first $13,000 of any gift to a child is free of the gift tax, so you're not going to run into any tax problems shifting up to $5,000 their way."