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Tuesday, February 23, 2010

The Million Dollar Roth Child

With a Roth IRA, you do not receive an income tax deduction for contributions, but your money grows tax deferred and qualified withdrawals are income tax free…forever! This creates an incredible opportunity to amass a small fortune for children. For example if a 10-year old made annual contributions of $1,000 to a Roth IRA until his age 22, by age 60 his $12,000 investment would be worth $268,000 based on 7% earnings. Compare this to a child who makes contributions beginning at age 22 and continuing those contributions until age 60. In this case, total contributions are $38,000 and his accumulated balance is $198,000. Through the power of time and compounding, our younger investor creates more wealth with less than a third of the money. If our young investor continued to invest $1,000 per year all the way to age 60, he’d have $466,000. And if we could figure out how to increase the investment to $5,000 per year, he’d accumulate an eye-popping $2.3 million by age 60!

Whether it’s a relatively small Roth IRA contribution or a maximum contribution, these are impressive numbers. In order to be eligible to make contributions to a Roth IRA, your child must have earned income. The rules allow a contribution of 100% of earned income up to $5,000. So how do we go about getting our ten-year-old earned income? Here are several possibilities:

1. Self employment income. Your child could have a job such as baby sitting or mowing the neighbor’s lawn. When I was twelve, I remember my father dropping me off in the neighborhood with a box of aerosol can fire extinguishers that I sold door-to-door. I bought the cans for $1 (with dad’s money!) and sold them for $3. That’s earned income that would qualify for a Roth IRA contribution.

2. Employment income. Typically, this would include after school or summer jobs such as working at a grocery store, golf club or restaurant. Here the child is drawing a paycheck from an employer. If the parents are self employed or sole proprietors, then they might hire their children to work in the business. The compensation must be ‘reasonable’ for the work performed and keeping excellent records is a must.

3. Household work. Children can qualify as household employees if they follow certain IRS guidelines (see IRS Publication 926 at www.irs.gov). Here, excellent record-keeping is vital.

Knowing that when children earn money they’re not likely to be very enthusiastic about investing in a Roth IRA, consider this strategy. You (or a grandparent) agree to gift them one dollar for every dollar they contribute to their Roth IRA. As a result, your children will learn the value of work, saving and investing for the long term and just maybe…become a millionaire in the process!


Correction: In last week’s column on estate planning, I indicated that under current law, the first $1.3 million of estate assets received a ‘stepped-up cost basis’ plus an additional $3 million for certain spousal transfers. The law actually allows an exemption for the first $1.3 of appreciation of estate assets plus a similar exemption of an additional $3 million for certain spousal transfers. My thanks to attorney Leonard Wertheimer for pointing this out.

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