I had a conversation recently with a friend. It was so great I thought I had to share with the blogosphere. This post is about how you can open a Roth individual retirement account (IRA) for your child to launch them into the wealthy stratosphere. These accounts are referred to as custodial or minor Roth IRAs. I’m going to keep this post short and give you a few links to read more if you find the topic interesting enough to continue your research.
A few things about the IRA:
- The Roth IRA is funded with post-tax dollars, so you contribute to it after you get your paycheck. Since taxes have already been paid upfront, your contributions and earnings grow tax-free, including when it’s time to make withdrawals.
- The traditional IRA is funded with pre-tax dollars so you contribute to it before income taxes come out of your paycheck, reducing your taxable income. This account is taxed when you make withdrawals.
- You will need to work with your employer to open a traditional IRA, if they offer it. My employer does not.
- Anyone with a social security number can open an IRA.
- There is no age requirement for an IRA; children require their legal guardian to open their IRA, called a custodial IRA.
IRAs are meant to fund retirement, so you will pay a penalty if funds are withdrawn before age 59½, with the following exceptions:
- Paying for school if you are at least a half-time student, including tuition, books, supplies, room-and-board, and required equipment.
- Buying a home. You can withdraw up to $10,000 from an IRA to buy, build, or rebuild a first home. If you and a spouse are both first-time home buyers, the amount increases to $20,000. Financing and closing costs are other eligible expenses. This tax loophole can also be used to purchase a first home for a parent, child, or grandchild.
- Disability. If you become disabled before 59½ and are unable to work, you can take contributions from your IRA.
- Military. If you are called to duty, for longer than 179 days, you can withdraw funds penalty-free during active duty.
Today I want to focus on the power of the IRA for parents to grow a nest egg for your children. Knowing that an IRA can be used for your child to pay for school and purchase their first home makes the tool even more powerful. Read more about the benefits here.
Don’t take my word for it, calculate the power of compound interest for yourself:
For this calculation we will use Vanguard’s go-to index fund for FIRE (financial independence, retire early), VTSAX. VTSAX has performed well over time, boasting 8.6% returns since inception, 16.3% return over the past 10 years.
With an initial investment of $12,000 over 2 tax years, assuming an 8.6% rate of return (compounded annually), my daughter’s IRA will sit at $1,032,000 in 54 years. This is if we add no money to the account ever again.
Of course, as she continues to earn income, we will add to her account and match her contributions. Let’s assume that on top of the initial investment, we put away $100 from my daughter’s earned income. Over the course of 54 years, a total of $76,800 will have been put into the account. With the power of compound interest, based on the VTSAX assumptions above, this initial investment will be worth approximately $2,220,000 in 54 years. The longer the money sits there, the more powerful it becomes. The earlier years, the account earns a few thousand per year in interest, but by year 50 the account is seriously snowballing, earning over $130,000 per year. Play with the numbers yourself by using the investor.gov compound interest calculator.
Saving a large lump sum is not an option for most people, that I understand. However, if you are a parent and your child has earned any income, or will earn any income this year, you now have some info about an option to grow that income from a seed into a mighty oak tree.
If you want to read another Black woman’s story about her plans to use custodial IRAs to make her children millionaires by their 30’s, click here. This is a powerful tool for creating generational wealth. As always, feel free to reach out. And one last thing, I’ve finally joined social media. Follow my instagram @the_wealthy_principal
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