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The unknown benefits of starting a ROTH IRA for your kid

Dear friends,

 I had a call from one of you last week asking about changing his teenage son’s 401K rollover into a Roth IRA.  I did some research and in the research I came across a great article in Forbes and quite frankly the numbers were staggering.

 In a nutshell because of the length of time till your child or better yet your grandchild reaches age 59 ½ the  compound interest can turn a small investment now into hundreds of dollars down the road, oh and with a Roth its tax free at the end.

  To illustrate ….

Calculate Future Value The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. This is a math equation not any guarantee or illustration nor is it a hypothetical just a math example. 

         Interest rate per time period   8%

        Number of periods                48

        Initial Investment               $5,000 or $10,000

        $ 5,000    returning an average of 8%  for a 12 year old, till age 60, future value could be approximately   $ 201,052 tax free

         $ 10,000   returning an average of 8%  for a 12 year old, till age 60, future value could be approximately   $ 402,105   tax free

Here is the article by William Baldwin published in Forbes, 4/8/2011.



Make Your Kid Rich With a Roth IRA    

Here’s a tax strategy that will, in one swoop, take money away from the IRS and help your kids make their way in the world. It’s powerful and at the moment vastly underutilized.

Set up a Roth retirement account for a youngster. Potential growth, undisturbed taxes, for 50 years. The kid spends it when he’s 69.

I know the technique is underutilized because I have encountered more than one financial institution befuddled by the idea that minors can have IRAs.

A youngster can put up to $5,000 a year in a tax-sheltered retirement account, but can fund it only with dollars earned working. You can help out with the dollars, but the child has to work in a real job.

“Ever heard of supply side economics?” you ask the kid. “Here’s an incentive. If you earn a dollar, I’ll give you another dollar. Your tax rate, not counting payroll taxes, will be a negative 100%. But you have to put the money I’m giving you away until you’re retired.”

If your daughter earns $4,000 as a lifeguard, you let her spend that money as she normally would (on college, if she’s expected to chip in, or if not then on whatever). You come up with the $4,000 to put in the retirement account.

With a Roth IRA the worker gets no deduction as the money goes in, but enjoys a full tax exemption on money coming out.

For a middle-aged worker the choice between a deductible IRA and a nondeductible Roth is a tough one to make. That’s because the deduction is worth a lot of money to someone in his peak earning years and therefore a high tax bracket. A 45-year-old worker has to weigh that benefit against the cost imposed at the other end: Every dollar coming out of a deductible IRA is taxable.

For a teenager working summers, the choice is not tough at all. For him, the up-front deduction is worthless. He’s probably in a 0% income tax bracket.

Here’s why. A student under 24 who can be claimed as a dependent on a parent’s return (and that would include a child you’re putting through college) gets a standard deduction equal to the sum of $300 and earned income. There’s a collar around this sum: The standard deduction can’t be less than $950 or more than $5,800. (The upper limit is up $100 from the 2010 figure.)

The effect of this formula is a little complicated for the child with investment income, but for one without investment income it works like this: The first $5,800 pulled down from a part-time job is free of income tax.

So the kid passes up the opportunity to deduct anything now and declares the account to be a Roth. At the retirement end the account, will be scot-free.

Will your offspring honor the promise not to touch the money for 50 years? You won’t be around to make sure. For what it’s worth, the IRS will help out by threatening a penalty on the earnings if there are any withdrawals before age 59.

Assuming you can persuade your bank or mutual fund company to open the account at all (with you as guardian, if the child is under 18), you may have some minimum account hurdle to overcome. But note that you can combine two years of earnings in one deposit. An IRA contribution can be made either in the year in which the earned income comes in or by April 15 (in 2011, April 18) of the year following.

So, a deposit next March could combine this summer’s earnings with a conservative estimate of what the earner expects in 2012. IRA deposits can if necessary be undone, within certain time limits.

Make your children into savers when they are young. If they don’t break the habit, they better position themselves to have more prosperity and less angst than most Americans.

One caveat: Colleague Janet Novack reminds me that you should think about how this move will affect college financial aid. While parents’ retirement accounts aren’t considered available to pay for college, the kids’ accounts generally are. In any event, an intergenerational gift almost never makes sense if it means starving the donor’s own retirement account.


I would enjoy your some feedback if you like or did not like the idea

Disclosure: The information contained is general in nature and should not be construed as comprehensive financial, tax, or legal advice.  As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action. 

To qualify for the tax free penalty free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after 59 1/2 or due to death, disability, or a first time home purchase (up to $10,000 lifetime maximum).  Before taking any specific action, be sure to consult with your tax professional. 

Example used as illustration only, not indicative of any particular investment, actual results will vary.  Past performance is no guarantee of future results.

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