Roth IRAs For All The Children!

by Bill Sweet

If you spend much time studying the basics of finance, one of the conclusions that should stand out is the incredible power of compound interest. Whether or not Einstein proclaimed it to be true, if it isn't the most powerful force in the universe, it is likely the most powerful force in long-term financial planning.

Most of the discussion that revolves around finance is unnecessarily complicated & nuanced, which is what makes this one stand out: if you save money early, and leave those funds alone for a long period of time, they tend to grow exponentially. It really should be that easy.

If you save early and often, you probably don't need to concern yourself with what the stock or bond market does this year or that, and can spend your time worrying about things that you can control and that actually matter to your life.

Source: JP Morgan Asset Management. This doesn't represent an actual investment, but I hope that you knew that already, but in case you didn't, there isn't any investment that is guaranteed to grow like this. Stop searching for it. Nothing happens in a nice, clean line. Believe me, I wish it did! All investment involves risk, and you could lose your principal. Not FDIC-insured. Consult with an investment professional licensed in your state who can get to know you and your specific risk tolerance and tax situation before making any investment decisions. I'm serious about this. 

The barriers to savings early are common and are the province of just about every living, breathing human being - life gets in the way. The rent needs to get paid, credit cards tend to pile up when not tended to, the bar tab doesn't pay for itself, and after all kids are very, very expensive. Also, YOLO. There will always be a reason not to save for the future.

Probably the most useful tool my arsenal against YOLO is the humble Roth IRA, which offers a great combination of features that make it useful to a wide range of clients. There is no up-front tax deduction into a Roth IRA, but that's about the only downside. Annual contribution limits for those of us under 50 are $5,500 per year, which is close to 10% of the median household income of $57,000 or so in the USA (this probably won't quite get the job done but is a solid start). Any investment growth compounds tax-free unless you take a distribution prior to age 59 1/2, but if you wait until after then, any distribution is generally received income tax free. The dirty secret of the Roth IRA is that you can get your basis back - the first thing that gets distributed is your contributions, not earnings, which is exactly the opposite of just about every other kind of investment. You should definitely consult your tax professional before you do this to be certain, but if you don't believe me, here's Publication 590. Read it and see if that makes sense before you do anything.

That's about as good as it gets. And we haven't even discussed what to buy within that Roth IRA, which is far less important than you might think.

The key ingredient is time. Time is what lets the interest (or potential investment earnings) compound, and when you have earnings on top of earnings, that is what really leads to the "most powerful force in the universe" thing. Typically, this process begins around age 22-25, or once someone's earning and life situation are stable enough to begin thinking about how to save for the future.

A law on the floor of Congress a few weeks back would open the door for young folks to open Roth IRAs a lot earlier than they can today. That would be amazing and incredible, but I think it's unlikely to happen, because, unfortunately, it makes too much sense. Sadly, our government isn't currently based on a system of making sense, but rather a system of making it easier to get re-elected.

Starting a Roth IRA at age 1-2 instead of age 22-23 could be potentially epic. Adding another 20 years for funds to grow completely income-tax free is something that I get very, very excited about. It might be difficult to convince people to sock away funds today for their kid's use in 60+ years when there seem to be more pressing concerns, but we'll cross that bridge when we come to it.

As it stands today, there really isn't anything that would prevent a parent from opening up a Roth IRA for their child, except for the very major hurdle of earned income. You see, an individual's Roth IRA contribution limits are $5,500 per year maximum (well, $6,500 per year over age 50), OR their earned income, whichever is less. There really aren't a whole lot of circumstances where a very, very young person would have earned income, since most child labor laws prevent meaningful employment until the late teens.

All of that said, an enterprising young parent could hypothetically put their kid on the payroll (with caveats, here), and with earned income, a Roth IRA account could be established.

I don't have kids, but if I did, this would definitely be something that I would be experimenting with.