The Roth-Child financial strategy

Stewart Welch By Stewart Welch
on June 05, 2014 at 2:31 PM, updated June 05, 2014 at 2:33 PM

Welch.jpgStewart Welch 

Summer is here and hopefully your teenager has a summer job.  I coined the name

'Roth-Child Strategy" to describe an idea for teaching your teenager the value of work and the benefits of saving.  With this strategy you can set your child on the path to becoming a millionaire!  The Roth-Child strategy is a play on words related to the famous Rothschild family.  You may remember that during the 1800s 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 16, whose summer job and other work-related earnings will be at least $5,500 for this year.  You agree to match her earnings with a dollar-for-dollar gift of up to $5,500, which she will use to contribute to a Roth IRA in her name.  Together you open an investment account (in your name as custodian for her) and together you 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 in stock investing.  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 16-year-old earning a small income.  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 50-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 percent return, by her age 65, 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 65, assuming a 10 percent return, her total Roth IRA account would be worth over $3 million!  If she chose not to tap this money during retirement but left it to her children, assuming death at age 90, 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.

Several 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 your Roth IRA,  whereas a traditional IRA has mandatory withdrawals beginning at age 70½. Children who inherit a Roth IRA must take annual distributions based on their life expectancy, but 100 percent of those withdrawals are income tax free.
  •          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 $6,200 in 2014 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 annual return for stocks over the past 60 years has been 10.7 percent.