Summer is a great time to teach your children about saving money for retirement and an interesting way to do it is by setting up a Roth IRA for them. Remember a Roth IRA is slightly different than a standard IRA. In a standard IRA you contribute pre-tax dollars and so it reduces the taxes you owe up front and it compounds tax-deferred but you still owe taxes on the entire amount when you withdraw it.
With a Roth IRA you contribute after-tax dollars so you don’t get a tax break up front but the money can grow tax free as long as it stays in the IRA and distributions can even be tax free if they are made after the age of 59½. This is a great compounding benefit. Plus distributions aren’t required to begin like a standard IRA so theoretically if they don’t need the money they can let it continue compounding forever.
The three major factors of compounding are time, starting value and the interest rate. Because your kids are still young they have plenty of time, because it is an IRA the government isn’t taking a chunk of the profits every year so more gets put back to work. And because there is a penalty for withdrawal it encourages your kids to actually leave the money in there and let the compounding actually do its magic.
So how does this system work?
Normally, people contribute to their own IRA so how can you contribute to your kids or grandkids? If they are working you can give them an additional incentive by “matching” any amount they earn. The law says they can contribute up to 100% of their gross income up to a maximum of $5,500 per year. You can give a gift of up to $14,000 per year per person before you have to worry about gift taxes. So theoretically [Continue reading]