Retirement savings doesn’t top the holiday wish list for many young people, but it should. You can help create the next generation of savers this season by gifting contributions to retirement plans and educating the children in your life about why your gift is worth more than an iPhone X or Nintendo Switch.
It’s simple math: $5,000 invested at the age of 16, growing at the historical average stock market return of 7%, will be $137,650 by age 65. The same $5,000 invested at age 26 would only be $69,974 at 65. That ten-year delay results in a reduction of almost 50% in ultimate return.
Those numbers raise the question, how can we encourage saving at an early age? How do we make compounding interest interesting when it’s not easy to put a bow on it and the tangible benefits are far off?
Here’s one idea you can implement now: make an annual gift to a child equal to the child’s earned income, up to $5,500. That gift should be made with an agreement that the money will go into a Roth IRA account that the child owns.
This arrangement has many benefits. Most important, it’s an extra incentive for the child to make earned income through a part-time or summer job. Second, the tremendous benefit of compound interest described above. Finally, it puts financial literacy into a real-world context and lets you work together with the child(ren) to develop a long-term investment strategy.
The stark difference in the growth of $5,000 invested at different ages makes it clear that saving young is worth more than this year’s hot gift. Now, consider the impact annual Roth IRA contributions would have after multiple years of summer or after-school employment.
We typically suggest a Roth IRA instead of a traditional IRA in this scenario but, like all financial decisions, this depends on personal circumstances. There are two reasons for this preference: (1) the child will likely not benefit much, if at all, from a traditional IRA deduction, and (2) eventual distributions from a Roth IRA will be tax-free.
As with all things tax-related, there are rules to be followed. The child will need earned income to make an IRA contribution and there are annual limits for the contribution ($5,500 in 2017 and 2018 or earned income, whichever is lower). This will have no gift tax consequences for any child in your life, no matter the relation, if you are mindful of the annual exclusion allowable when making other gifts. The annual exclusion for all gifts made in 2017 and 2018 is $14,000 and $15,000, respectively.
Financial education is important to start early and compound interest is a powerful first topic. Call on Drucker & Scaccetti if we can help you begin the conversation with the children in your life. After all, it is the season of giving!