Why fund a child's Roth IRA?

In my previous post I talked about how to save on your taxes by paying your children. I also encouraged parents to use at least some of those wages on funding a Roth IRA. A couple of people have since asked why a Roth IRA instead of a regular IRA or just normal brokerage accounts?

A Roth IRA offers significant advantages over either of the other two investment types and could be a great tool for teaching your children.

Compounding what?

As many individuals, wiser than I, have noted, a young person's best asset is time. By the miracle of compounding interest, the earlier a person saves the greater the benefit. Just about everyone has heard the tale of how Jon started saving $1,000 a year at age 20 while George started saving $2,000 a year at age 30. When they each turned 50, Jon had considerably more money than George.

Unless you are in the business of start-ups (where fortunes are created and lost in a matter of days), nothing helps money more than time. If I could magically speed up the clock and jump 30 years forward I would find that not only are my houses all paid off, but they are worth over 3 times as much as they were (assuming a conservative 4% appreciation each year).

So help give your children a head start on saving for their future life, and help them learn to start saving money now.

Why into retirement?

So if we're going to help our children save, why not put that money into a more typical brokerage account? Why put it into a retirement account?

I've never been impressed more than with Warren Buffett's decisions to leave the vast majority of his wealth to charity. Buffett refers to the children of wealthy people as "the lucky sperm club" and repeatedly insists that to pass along great wealth to your children can often hinder them, instead of help them. The author of The Millionaire Next Door agrees, and makes a strong case in his book that giving too much money to a child will make them more dependant on you, not less.

A popular trend that is emerging these days is to pass on your wealth to your children, but to limit their access of it until certain periods of their life. A certain amount might be accessible immediately, a little more might be given to them when they hit 30 or 40. Usually the entirety of the amount is passed along when the child reaches 50 years old.

The theory behind this method of disbursement is that by delaying the balance of money until the child reaches 50, they will have to work hard throughout their lives and earn their own money. They only receive the exceptional gift at a point in their lives when they are set in their ways and unlikely to make any significant changes to their lifestyles.

The same philosophies are true with any gift of money. Any unexpected money is likely to make your child more reliant on the source of that money than less. Let's look at an example where you put $3500 of your child's yearly wages into a stock index fund, between the ages of 10 and 18. The fund returns an annualized average of 10%. By the time your child heads off to college he'll have over $47,500 stashed away in those accounts.

Think back to your post-high school years. What would you have done with $47,000? Would you have made a down payment on a nice home? Or would you have bought a bitching BMW Z6 convertible? Maybe you would have let it sit. But more likely you would have spent every spring and summer in Cancun.

The advantage of an IRA is that the government tries hard to discourage people from taking money out until they are 60. It helps even more if your child doesn't have direct access to the broker in charge of the account. By putting the money in the hands of a retirement account, you've helped limit the allure that the cash holds over all of us who have windfalls.

Retirement account have other added benefits as well. When your child decides to purchase their first home, they can withdraw up to $10,000 out of their retirement plan without penalty. If something happens and some medical bills pile up, those can also be paid for out of their retirement plan without penalty. By building a retirement account for your children, you have given them a safe cushion to protect them from disasters, but kept them from wasting it away themselves.

Pay taxes and die

There's an old saying that says there are only two certainties in life, death and taxes. The first may be completely unavoidable, but the second can be dodged from time to time with careful maneuvering.

A traditional IRA is a retirement vehicle that allows you to reduce your taxable income today at the expense of future taxes. For example, if you earned $100,000 this year, but put $10,000 of it into a traditional IRA, then your taxable income would be $90,000, saving you roughly $3,000 in taxes. However, when you withdraw that $10,000 later in life you'll have to pay taxes on it. The IRS eventually does get their hands on that money, they just have to wait for it.

Out children, however, don't have to deal with paying much (if anything) in the way of income taxes. If their income was under the standard deduction, then they will pay nothing in income tax. So they should be looking at using a Roth IRA instead. A Roth IRA taxes you on your income now, but the benefit is that when you take the money out later you pay no taxes at all. That $47,000 we helped our children raise in the previous example will be 100% tax free when they retire. And since they didn't have to pay any taxes on it when they put the money in, the result is a retirement fund that the IRS will never touch.

For further reading on IRAs and Roth IRAs, take a look at the IRS's official pamphlet on the subject. It's a bit dry reading, but at least it's not written in legalese.