Several of my recent blog posts have dealt with managing children and their expectations about their parents’ wealth (here and here). In today’s post, I’ll discuss how to help children (especially teenagers) get started in building wealth of their own, focusing particularly on one important tool: the Roth IRA.
Roth IRAs effectively offer taxpayers the opportunity to pay income tax on assets now and then never pay income or gains tax on those assets again. Roth IRA accounts are funded with after-tax dollars, which then grow tax-free, and which may be withdrawn tax-free once the account owner is over the age of 59 1/2. (Withdrawals made prior to 59 1/2 are subject to taxes and penalties). Because this structure is so advantageous to the taxpayer, the IRS limits those who may contribute to Roth IRAs by setting thresholds based on modified adjusted gross income. When taxpayers’ income reaches the threshold range, they either have lower contribution limits or lose the ability to contribute to Roth IRA accounts entirely. For single taxpayers, the income phase-out starts at $122,000 in 2019, while married filers reach the beginning of the phase-out range when income crosses $193,000.
While taxpayers must have earned income in order to contribute to a Roth IRA (investment income does not qualify, nor do capital gains) the IRS does not care whether that earned income is the source of the Roth IRA funding. This is where parents and grandparents come in. When a child gets his or her first job, contributing to a Roth IRA for that child’s benefit is the most powerful, tax-efficient gift a loved one can make. Consider the following example:
Emily gets her first job at 15, where she makes $6,000 for the year by landscaping and shoveling snow. Her parents contribute $6,000 (the 2019 maximum contribution) to a Roth IRA on her behalf and then never contribute to the account again. For round numbers’ sake, let’s assume Emily’s parents had to earn a gross of $9,000 in order to net the $6,000 they put into her IRA (meaning that her parents are in a combined 30% federal and state marginal income tax bracket). If the underlying investments in the Roth IRA earn 5% annually, Emily will be able to withdraw over $72,000 from the account when she turns 65 – and she will owe $0 in taxes on these withdrawals. The entire “tax cost” of making this gift was only $3,000 in today’s dollars (the income tax mom & dad paid on their $9,000).
Then consider Emerson, who is in the same situation, but whose parents opt instead to contribute to a traditional IRA on his behalf. In that case, the $6,000 would also grow to over $72,000 in the tax-deferred IRA, but Emerson would then lose about a third of that amount to income tax when he withdraws the funds. He would also be forced to begin withdrawing from the account at age 70 ½ (traditional IRAs require these annual age-based distributions, whereas Roth IRAs do not). Emerson would get a $6,000 tax deduction in the year the IRA contribution was made, but that is likely not worth much, as most teenagers do not have enough earned income to push them into very high tax brackets (taxpayers only pay 10% federal income tax on the first $10,000 or so of taxable income and 12% on the next $30k of income). Even if Emerson is the Warren Buffet of landscapers, the deduction would likely only save him about $720 in federal income tax now ($6,000 deduction at 12% federal income tax) – a small savings compared to the tens of thousands he’d owe in income tax when withdrawing from his traditional IRA.
The Roth IRA offers superior tax treatment and more flexibility than the IRA, while still providing for tax-deferred growth under the same retirement account structure. These are some of the factors that make the Roth IRA the vehicle of choice for many families looking to gift to children while also helping plan for the children’s retirements and get their children engaged in investing. To consider just how powerful the Roth IRA can be as a gifting vehicle, let’s re-consider Emily’s Roth IRA. What if, instead of making a one-time contribution, her parents funded $6,000 annually to her Roth starting when she was 15 through her college graduation at 22 (essentially making seven annual contributions of $6,000). If we assume the same 5% investment return over that time, Emily will have about $50,000 in the Roth IRA at graduation. If she then leaves that account alone for 43 years (until turning 65), she’ll have access to over $425,000, completely tax-free, in retirement.
Gifting to children and grandchildren can be one of the most gratifying (and scary) elements of a financial plan. There are a variety of mechanisms available to parents and grandparents, depending on the size of the gift and the ultimate objective. If you would like to discuss the options available to you and your family, please reach out to our planning team.