When the Vondruska family gathered on Christmas Eve to open presents, the grandchildren did not open any packages from their grandparents.
Instead, George and Susan Vondruska handed their three granddaughters, who are in their early 20s and working, notes that say they now have Roth IRAs (US retirement plans) worth $5,000 each.
“Think of how large this can be if they retire in 45 years,” said George Vondruska.
It could be quite large, indeed.
That initial lump sum could become more than $150,000 for each granddaughter at retirement. That assumes an average annual return of 8 percent on a portfolio about 82 percent in U.S. and international stock index funds and the rest in bond funds.
The grandparents picked Roths because they are such a powerful retirement savings vehicle. The growth is never taxed if invested until at least 59½. A person needs to have earned income to qualify each year for the contribution, with a limit of $5,500 for 2018. But the IRS does not actually see who puts the cash into the account.
Parents or grandparents who already have their own retirements squared away are incentivizing young people to save by starting the accounts as soon as the kids have earned income from a job - even babysitting or lawn mowing.
Here is what you need to know about seeding a Roth for the young people in your family:
1. It is never too early
Financial planning trainer and certified public accountant Ed Slott preaches starting young, noting “the magic of compounding, or what Einstein called the eighth wonder of the world. And it grows tax-free forever.”
Parents with businesses can even hire young children and pay them with a Roth IRA, said Slott. But to qualify, children must be hired for real work; at appropriate pay. “You can’t hire your child to clean his room,” said Slott.
2. Know the rules
Roth IRAs are not technically gifts, so gift tax rules do not apply. A parent or grandparent can provide the money, but it cannot equal more than a child earned in a job or business during the year and the limit is $5,500 in 2018 and $6,000 in 2019.
When Boston-area financial planner Maureen Demers’two oldest children started summer jobs in a friend’s sandwich shop at 15, she waited until they received their W-2 forms to make sure she knew what each had earned. By tax time the kids had spent the $800 they earned, but Demers filled out paperwork at Vanguard to open each a Roth and deposited the full $800. She plans to do the same for a child in high school and a first job this year.
There is usually no need to file a tax return unless a worker has earned $12,000 or more this year. Demers did it anyway to recover the withholding from the summer work.
3. Consequences for college aid
A Roth IRA is a child’s asset, which means that if a child needs financial aid to afford college, a family could face a reduction in aid of up to 25 percent of the Roth’s value at some private colleges, notes Kalman Chany, author of “Paying for College Without Going Broke.”
This is not an issue at public colleges, where the FAFSA financial aid application ignores retirement accounts of both parents and students.
But private colleges do delve into a student’s retirement accounts and other assets with the CSS Profile form, which requests financial aid. The college could require a student to withdraw Roth IRA money and use it for college. In that case, the withdrawal would be considered income and that income could reduce aid by another 50 percent during the next college year.
4. How to invest
The key to choosing investments, especially when the sums are small to start is to “make it simple,” said Demers. She suggested a total stock market index fund like Vanguard’s, which is a low-fee exchange-traded fund (ETF) with no minimum that mimics the full stock market and can be held for life. She warned grandparents not to invest conservatively for a child, who has years to recover from a bear market. These can be purchased through any discount broker or brokerage accounts at fund companies such as Vanguard and Fidelity.