While most are distracted by the holiday rush, I’d like to suggest a gift for the young people in your life that could endure a lifetime. It’s perfect for those who have started working but have not been able to get their long-term savings started. In a small way, it can be used to build a legacy for generations.
It uses a legal although gaping tax loophole known as the Roth IRA. Most of us think of a Roth in the context of retirement savings, but for those in their teens and twenties the Roth is magical.
For your young loved one to qualify for a Roth, there are three major considerations. First they must have employment income. It doesn’t matter how underpaid they might be, but in order for them to qualify for a Roth contribution they must earn at least as much that year as you contribute in their name. Second, they can’t earn too much. In 2012 once a single person has an adjusted gross income of $110,000 ($173,000 for a married person), the maximum contribution decreases. Finally the maximum Roth contribution for 2012 is $5,000 and steps up to $6,000 for those 50 and over. Limits are scheduled to increase by $500 for 2013 and the deadline for a 2012 contribution is April 15, 2013.
Imagine your 20 year old son has earned $8,000 this year through working part-time. You can fund a Roth IRA in his name for $5,000. He could wait until he retires to take distributions, again without tax. If he needs the funds sooner, he could take out the contributions without tax although earnings may be subject to penalty and tax if the distribution is not qualified. If for some reason he doesn’t need the money during his lifetime, under current rules he could leave the Roth to his children. They could then take distributions over their life expectancies free of tax. It’s easily possible that by putting funds in a Roth IRA now that those funds will achieve over ninety years of tax free growth.
Which way do you think tax rates are headed? With the federal government over $16 trillion in debt and other future liabilities such as Social Security and Medicare at approximately four times that amount, it’s clear that benefits will need to be reduced and taxes increased. By putting funds into a Roth IRA for a loved one, you are avoiding the impact of higher future taxes.
If you put $4,000 into a Roth IRA for your child each year from ages 20 to 24 and he earns 8 percent annually on those funds, then by the time he turns 85 he would have $2.8 million. Distributions would be tax free and he could leave those funds to his children. In contrast, you put the same funds into a taxable account and assume 30 percent state and federal taxes each year, then he would only end up with about $656,000.
What if he needed those funds sooner than age 85? At any time you are able to take as much out of the Roth as has been contributed. So under our last example, at age 25 your son could take $20,000 out of the Roth free of penalty or tax. He may be able to take out earnings as well if he uses the proceeds for a first time home purchase or other qualified expenses, although they may be taxed.
So buy your child or grandchild a Roth, invest it in a low cost diversified mutual fund such as Vanguard Star, and your gift can lay the foundation for decades of tax-free growth.
Dave Gardner is a certified financial planner with a practice in Boulder County. He can be reached at yellowstonefinancial.com.