Hey, quick question for you.
What money lesson did your parents teach you?
For me, I distinctly remember my parents teaching me that it was important to be loyal to the company I worked for. To work hard, save money, and be safe with money because it’s hard to earn and easy to lose.
It was a great idea when pensions were the main retirement income, college was cheaper and a master’s degree secured a 6 figure salary.
But today, a college degree is a bare minimum to even get your resume looked at, nobody gives pensions anymore, and we can’t rely on savings alone because interest rates suck and what’s worse (and better) we are living longer than ever.
That old financial advice our parent’s taught us just doesn’t cut it anymore.
So when people ask me what am I doing to get my kids financially ready for the brand new world I tell them that in addition to teaching them the value of money, and saving, but I’m also teaching them how to maximize their efforts and make their money work for them for present and their future.
You already know that I believe in the need for adding a Roth IRA to your portfolio, but now I’m going to tell you why it kicks a$$ as a part of your kid’s portfolio too.
You can Open at Any Age!
With Roth IRAs you can contribute at any age as long as you have earned income.
My son does work in our company that we would have had to pay someone to complete – like stuffing envelopes, adding postage, etc. We pay him market wages (about $25 a month ) on a 1099 and he can put that income into a Roth IRA.
Since I’m not a total slave driver and because I still want him to enjoy his money, I also match his earnings so he can have spending money. He works and gets paid modest wages, I deposit his earnings into a Roth IRA and I give him (match) his earnings. This allows us to stay within the IRS guidelines and still teach our little one the value of saving for one’s future self.
Now, if you are wondering why I only pay for REAL work and not chores, it’s because I don’t believe in paying for my kids doing activities which are basic contributions to the family unit (assists in keeping where we live clean). I don’t get paid to clean the house and they won’t either. But that’s another story for another time.
Back to the Roths.
Just like with your contributions, he can withdraw them at any time for any reason without penalty, meanwhile, his earnings continue to grow, or leave everything in the account until he is at least 59 1/2 years old. Now imagine the nest egg on that baby if it is growing for 56 years! You don’t even need to do the math, I’ll tell you.
Over 3 million if he only contributed $5500 per year and made 8% interest (factoring inflation).
Either way, it’s a great way to teach him about income, investing, saving for the future, and maximizing tax advantages. At the moment, he only gets about $500 a year, but while it sounds awful, I’m excited can’t wait to get my kid working more so they can learn the money management tips I’m learning at 30 years old!
It doesn’t impact college financial aid
I know you are wondering why that matters when he’s only four but bear with me for a second.
I’m a firm believer in always thinking ahead to where you see yourself 25 years from now. And I have learned to stop dreaming small. So these days, any choice I make I plan out for my ‘dream board realized’ plan. So I’m thinking of college already.
When it comes time for my kiddo to go off to college, when he submits his FASFA for financial aid, his Roth IRA will not count as income since it is considered a retirement account. This means he will still qualify for merit and need-based aid when he goes off to college if we end up needing it.
Had we saved in a 529 or a CESA account, it would be factored in as my son’s funding to add to his education (not the end of the world, but I rather save money where ever I can).
Compound interest over half a century rocks!
Albert Einstein is rumored to have said that “compound interest is the most powerful force on earth”. I don’t know if that’s true, but if it is, then that’s real talk, Albert!
I’ve said it before, but the JP Morgan Chase Retirement Guide shows just how powerful compound interest is. This kind of wealth-building possibility deserves another look. Here’s how JP Morgan Chase describes it.
Imagine these 3 friends in the image above:
Chris invests $5000 each year from age 25 to 65. With a 7% return, by the time he turns 65, he’ll have over $1million! That’s a little less than 500% return.
Susan invests $5000 each year from age 25 to age 35. After that, she stops investing but leaves the money invested. With the same modest return, by the time she turns 65, she would have saved over $560,000. For just $50,000 investment over the course of 10 years, getting half a million is pretty badass.
Bill, on the other hand, waits a few more years before deciding to get serious about saving. He invests the same $5000 per year, but invests for longer since he’s catching up, and invests from age 35 to 65 (over 30 years) with the same return. Overall, Bill invests 3 times the amount of money Susan invests and is able to save a little over $500,000 when he reaches 65.
Once again, you can’t beat the ‘magic’ of compound interest!
It’s there if he needs it.
If something catastrophic, or incredibly awesome happens, he can withdraw earnings without taxes and penalties before retirement (under certain conditions)
In order to take advantage of withdrawing your earnings without penalty and taxes, you must be 59 ½ years old or older and have had the account for at least 5 years. But here are a few scenarios where if you meet the criteria then you are able to avoid paying taxes on your earnings:
The distribution is due to1:
- The IRA owner is totally and permanently disabled per IRS Code Section 72(m)(7).“You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration”
- Are used to pay for un-reimbursed medical expenses that exceed 10% of adjusted gross income (AGI)
- Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks
- Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members – you, your spouse, or the children or grandchildren of you or your spouse.
- Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.
- You use the distribution up to $10,000 to buy, build, or rebuild a first home.
So, if the crap hits the fan and you are in a real financial bind, like a massive medical bill, become disabled or need a deposit for my first home, the Roth IRA can offer an excellent exit strategy.
Invest how you like and there’s no limit to how much it can grow
With a self-directed IRA, his account can be used to fund any investment (with only a couple restrictions) and can reach unlimited growth absolutely tax-free.
His contributions would have decades to grow. And once he starts contributing more with higher earnings, then with sound investments and returns he could have millions tax free before it’s time for retirement.
Of course we are blue-sky dreaming here but the point is there is no limit on his earning potential. He just has to start contributing.
Your earnings are tax-free!
If you purchase an income property without a mortgage using your Roth IRA, then the rental income you receive is tax-free! There are some specifics to follow of course and will take more details, but where else can you find tax free income?
This is great news for us, who purchase income properties and wonderful news If my son at some point decides to purchase a rental property with his Roth IRA, then he’ll get even added benefits. And again, because you always have to keep your exit strategy in mind, if he needs it right away he only pays a 10% penalty to withdraw. Which is still better than most tax brackets.
Minimized tax bite in retirement since the kiddos have low brackets now
It doesn’t matter whether you think taxes will increase or decrease in the future. Taxes are based on income and with my 4 year old earning a very very low income from working with the family business, it is guaranteed that his tax bracket will be lower now than he will probably ever be in his life. That’s one of the reasons the Roth IRA is a great tool.
Contributions are made with after-tax money so taxes are paid upfront while in a lower tax bracket. Once retired, you get a tax-free stream of income and that’s a sweet deal when you are cashing out decades of compounded interest.
That’s right, your contributions and earnings (all that $800,000+ if you invested like Chris in the above example) is TAX-FREE! Imagine what the tax bill would be on that chunk of money if it was in another vehicle!
Where do you start?
Don’t you want to be the parent that sets your child up, not just for the future, but for retirement too?
And more than just a savings account where you give your kid a fish, instead you will be teaching them the importance of saving for the future and the power of compound interest thereby teaching them HOW to fish!
Imagine the relief your child can feel in college to know that things will get easier because they have started to plan in motion to retire the way they want and at the same time have a buffer if things go south.
I don’t know about you, but that’s who I want to be. If you are thinking about opening a Roth IRA for your kiddo, then know that to open a custodial account for a minor you can use Fidelity, Equity Trust (Self Directed), Charles Schwab, Vanguard or T.Rowe Price and maybe a few others to get started.
Don’t get me wrong. It’s not perfect, but the advantages are undeniable. If your kid is babysitting, cutting the neighbor’s grass for a wage, selling bottled water at the local games, whatever it is, use it to build the wealth for their own future.
Now that you know some of the secret awesomeness of the Roth IRA what are you gonna do?