Tax Tips
Why Your Kids Need a Roth IRA
It doesn't wrap very well, but putting your kids on the path to retirement security is a gift worth giving.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
December 2009
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The holidays are fast approaching, and you're wondering what to get your favorite teenager. Rather than shop for the latest trendy fashion or iPod accessory, why not give a gift that could secure his or her future? Consider funding a Roth IRA for your child or grandchild.
For this to work, the child must have had a job in 2009 because only people with earned income can have an IRA. (Investment income doesn't count.) So if your teen made money delivering papers, baby-sitting, flipping burgers, or working any other after-school or weekend job, he or she qualifies.
And nothing in the rules says that the child's own money has to go into the IRA. It's fine with the IRS if you give your son, daughter or grandchild the cash. The key is that no more can be contributed to the Roth IRA than the worker earned on a job.
This year, individuals can put up to $5,000 into a Roth IRA. Even a small contribution now can add up to big bucks in the future, thanks to the power of long-term compounding.
Let's say you give your 15-year-old daughter $1,000 to fund a Roth IRA. If the money inside the account grows at an annual average rate of 8% -- well below the long-term average return for stocks -- that $1,000 will grow to about $47,000 over the 50 years it takes for today's teen to reach retirement age. If you put in another $1,000 each year until she turns 20 -- and then never add another dime -- that $5,000 investment would be worth nearly $250,000 by her 65th birthday. With a Roth IRA, the full amount will be tax-free when it's withdrawn in retirement.
In addition to setting your kids on the road to retirement security, the gift of a Roth IRA can help them realize more-immediate goals. Because contributions are made with after-tax dollars, they can withdraw the contributions (but not earnings) anytime, tax- and penalty-free. In addition, once the account has been open for five years, up to $10,000 of earnings can be withdrawn tax- and penalty-free if the money is used to buy a first home. It's hard to think of a better gift this holiday season.
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Reader Comments (6)
Posted by: Virginia Luna at 12/15/2009 09:18:06 PM
Our company just announced we were purchased, I currently have a 401K and pension which I have to cash out, roll over to an IRA or roll it into the new company's 401K. I don't know a lot about my options and would like to shop around for best return. Could you assist me with maybe comparing the current company vs the new company?
Posted by: kevin mccormally at 12/16/2009 09:06:09 AM
Kevin McCormally of Kiplinger here, with an answer for Virgina Luna. First, if your vested balance in the plan is more than $5,000, you don't have to cash it out when you leave the job (if you're under 65). The law says you can keep it in the plan. That said, we generally think it's a good idea to take your money with you, by rolling it into an IRA or the new employer's plan (if that plan accepts roll over). To compare the two 401(k)s, you need to look at the investments offered by each. Sometimes, using an employer plan gets you lower-cost investing than using an IRA; sometimes not. Overall, you may be best off rolling your money into an IRA, so you have almost unlimited choice of where to invest and complete control over the costs. One disadvantage if the IRA choice is that you can't borrow from an IRA, whereas you can borrow from a a 401(k). Another advantage of the IRA is that you can convert it to a Roth IRA. You have to pay tax on the amount you convert, but that buys you tax-free growth in the future, rather than simply tax-deferred growth, which is what you get in a regular 401(k) or IRA. Hope this helps.
Posted by: TAS at 12/18/2009 01:22:46 PM
Mary Beth Franklin shows us how money invested will grow, but don't we have to factor in inflation to really understand how much money we might have after an extended period of time? Based on Virgina's scenario, how much could my daughter expect to have at 65 using same numbers but including inflation or expected deterioration of the U.S. dollar? How would one perform the calculation?
Posted by: wolf at 12/24/2009 08:21:35 PM
My wife and I gave as a wedding present to our granddaughter and her husband Traditional IRAs. We considered ROTHs IRAs, but we chose the Traditional because, if they were in a financial pinch, they may take out the ROTH contributions free from tax and free from penalty. We really want this young couple to think long and hard about taking an early distribuiton from their IRAs. It will cost them something.
Posted by: David Oakes at 01/07/2010 12:28:03 PM
My wife has a 401K at an old employer. This 401K has both pre-tax and after-tax money in it. Can we convert only the afer-tax money into a Roth IRA without incuring any additional taxes? This 401K is being administered through Fiedlity NetBenefits.
Posted by: Laura at 07/12/2010 06:58:42 PM
I don't know of ANY Roth that comes even close to earning 8% these days!!!