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By Stewart Welch, reposted from AL.com:
How would you like to help your child blaze a path towards becoming a multimillionaire and teach them the value of hard work and the importance of saving for the future all at the same time? Here’s a concept that I call The Roth-Child Strategy… a play on words related to the famous Rothschild family. You may remember that during the 1800’s the Rothschild family accumulated what was believed to be the largest private wealth in the world. Their name is synonymous with wealth even today. The Roth-Child Strategy harnesses the combined power of the Roth IRA along with the power compounding of investment returns over long periods of time. Here’s an example of how it might work:
You have a daughter, age sixteen, who has a summer job as a nanny-sitter for a family. She’ll earn $13 per hour working five days a week from eight in the morning until six in the evening. Her total weekly wages would be $650. Over the course of nine weeks, she’ll earn $5,850. You agree to ‘match’ up to $5,500 of her earnings by contributing to a Roth IRA in her name. Together you open an investment account and decide how to invest her money. Since she’s very young, it would be entirely appropriate to invest 100% in stocks or stock mutual funds. Well researched stocks in companies that she can relate to may create more lasting interest for her. Companies like McDonald’s, Apple, Microsoft, and Verizon are great companies whose products she likely uses often. These companies also pay dividends and have a history of raising their dividends over time which would be another great thing for her to observe.
I recommend using a Roth IRA because of its unique characteristics. Remember, you don’t receive a tax deduction for contributions to a Roth IRA. Perfect…since a tax deduction would be worthless for a sixteen-year-old earning $5,850. Once the money is invested, it grows tax-deferred, meaning there are no current income taxes on interest, dividends or capital gains. Even better, at retirement, all distributions are tax free! The Roth IRA is the perfect incubator for growing wealth for a teenager!
I think you’ll be astonished at the effect of tax free compounding over fifty-plus years! Let’s take a look at how the ‘numbers’ might work. If during this summer, you invested $5,500 in a Roth IRA and assuming a 10% return, by her age sixty-five, her account would be worth over $500,000!
Let’s take this strategy a step further. Let’s assume you do this every summer until she graduates from college. Over six summers you will have invested a total of $33,000 and by her age sixty-five, assuming a 10% return, her total Roth IRA account would be worth over $3,000,000! If she chose not to tap this money during retirement but left it to her children, assuming death at age ninety, your grandchildren would inherit a whopping $33 million! All of this because you chose to encourage her to work, save and invest. Now that’s what I call a great legacy!
A couple of technical points are in order. To contribute to a Roth IRA, you must have earned income. You are allowed to contribute dollar-for-dollar of your earnings up to the Roth IRA limit, which this year is $5,500. Under current law, you are never required to take withdrawals from a Roth IRA whereas a traditional IRA has mandatory withdrawals beginning at age 70½. When your grandchildren receive their inheritance, it too, will be income tax free! According to Ron Stokes, CPA of Birmingham, Alabama, “The daughter will need to file a tax return as evidence of earned income. Assuming this is W2 income (wages versus self -employment income) and there is no unearned income, it will be a simple tax return and she could earn up to $6,100 in 2013 before owing federal taxes.” I’d encourage you to have her fill it out and file it herself (you can help her but don’t do it for her). The historical return for stocks over the past sixty years has been 10.7%.
If you’d like to have me answer your financial question email me at email@example.com and place AL.com in the subject line. Consult your own professional legal, tax or financial advisor before acting upon this advice.
Stewart H. Welch III is founder of The Welch Group (www.welchgroup.com), which specializes in fee-only investment management and financial advice to families throughout the U.S. Welch is the co-author of “The Complete Idiot’s Guide to Getting Rich” (Alpha Books) and “J.K. Lasser’s New Rules for Estate and Tax Planning” (John Wiley & Sons). If you’d like to have me answer your financial question email me at firstname.lastname@example.org and place AL.com in the subject line. Consult your own professional legal, tax or financial advisor before acting upon this advice.