By
I smiled because I tried the same thing when Roths first came out and I'm sure many, many parents have thought of the same thing. We all want to make our kid's lives easier than our own and starting to save very early in life is one of the surest ways to do so. In the equation "contributions x rate of return x length of time = moola," time is the most important factor.
I used to amuse myself by playing with my HP 10B calculator, which does TVM (Time Value of Money) calculations useful for amortizing your mortgage or projecting the growth of savings and investment accounts. It's rather fun. As someone who is nearer to retirement than I would like to be (from a savings point of view only!), it was quite annoying to realize that no matter how I played with the numbers, time was always the most critical factor, and the more time, the better.
Suppose you plan to put $2000 a year into a Roth account to fund your retirement. That's the contribution factor. The average rate of return governs how fast that money will grow. Assume a 10% rate of return and each year's contribution will double every seven years (approximately). Assume a 15% rate of return and they double every five years. Assume a rate of return of 20% (my goal) and each contribution doubles in less than four years. Rate of return is very important, but time, oh, time, time is the biggie.
Here's what I mean:
Say you contribute your $2000 faithfully every year and earn a very respectable 15% for the next 30 years. In year 30 you will have a million dollars. But in year 35 -- just 5 years later, you will have two million dollars. That's right, 30 years to earn the first million and just five (at the same average rate of growth) to earn the next million. The corollary of that is that after 10 years, you've only amassed $50,000, and if you aren't aware of how this works, that can look rather discouraging to you at that point. Because you are compounding on previous gains, the more time that passes, the bigger the gains are, in dollar terms, even though the rate of growth is the same.
Increasing your rate of return has a big impact as well, of course. Averaging 20% per year means you get to that first million dollar mark in just 25 years and you've doubled it again by year 29. No one complains about that, but it's a lot easier to wait six years than to increase one's average rate of return by 33%! That's the trade off: Time vs. rate of return. In this particular example, you can get to two million dollars by either increasing your rate of return by 33% or by increasing the time factor by less than 20%.
Suppose you were able to earn 10% a year, well below what stocks have returned over the last 50 years. You still hit the one million dollar mark around year 41 and the two million dollar mark in year 48.
Now, here's the clincher. Suppose you stop the annual contributions at some point, say after 10 years. What impact does that have? With a 15% rate of return, it takes 32 years to get to the one million dollar point -- two additional years, even though you only contributed for 10 years instead of 30. And you still hit the 2 million dollar mark in another 5 years. At the lower rate of return, 10%, the impact is greater, but only slightly. Instead of taking 41 years to get to the million dollar point, it takes 45. Yep, those first few years of contributions are really important, but after a while, the contributions become almost irrelevant.
It's no wonder that parents with spare cash dream about starting a Roth for their children. We all worry about the future, and the surest way to make that future secure against whatever the market does is to start investing early while there is plenty of TIME.
Unfortunately, you can't. Not with a Roth, anyway.
A Roth IRA can only be funded by the earned income of the account owner. (That's real sweat-of-the-brow type earnings. Unearned income like dividends and capital gains don't count.) Unless your children are unusually talented, most of them won't have earned income in their elementary school years. Some kids do earn money through modeling, stuffing envelopes for mom's home business or the occasional patent, but allowances don't count unless the kid is really working for the money and if you try that one, you would want to check with a good tax advisor, and maybe a lawyer. I suspect Uncle Sam has already nipped that plan in the bud.
Well, darn. There's always the Education IRA (an Education Individual Retirement Account? Is that for funding cooking classes at the Senior Center?) The Educational IRA's $500 limit has discouraged many people from even bothering with it, but come freshman year, or the first year of grad school, I suspect its merits will be more apparent.
But that's not what we are talking about. We're talking about ways to insure the financial future of our children. Of course, a good education is an excellent way to do that, but in strictly monetary terms, the next best thing to a Roth IRA is, surprise, a regular ol' brokerage account. As long as you don't sell any shares, you don't pay any taxes so those capital gains just keep compounding, tax free, until you sell them. Of course, you have to pay the capital gains taxes if you do sell one that has gains, but that can make you a better investor by encouraging a real buy-and-hold mindset. In fact, a brokerage account in the hands of a true long-term, buy-and-hold investor can be a better retirement vehicle than a traditional IRA or a 401(k) plan, especially one that doesn't have employer matching.
That's because withdrawals from all retirement accounts except the Roth are taxed at regular income tax rates. But the new super long-term capital gains rate reduces taxes on assets held more than five years (starting next January 1, with the usual caveats and exceptions), to as low as 8% if you are in the 15% tax bracket. Even those in the highest income tax bracket will pay only 18% on those super long-term gains. By contrast, withdrawals from a regular IRA or other retirement account, except the Roth, are taxed at 15 to 39.6%.
Before you start writing your congresspersons about this inequity, do take into consideration that the reason IRA gains are taxed at regular income tax rates is because you got a tax deduction on the money that went into them in the first place. And you were able to buy and sell all those years without paying taxes (or even tracking the transactions) so your money grew untaxed and all of that cash that would otherwise have been pulled out to pay taxes just stayed in the account and compounded. It's not as inequitable as it seems at first.
It does make one wonder about the value of putting money into a 401(k) plan that is beyond the level that is matched by employer contributions, though. And it means that it makes absolutely no sense for most people to continue to put money into a traditional IRA. (OK, there's probably someone, somewhere, for whom it makes sense, like someone who intends to take out all contributions and earnings within five years, but most folks can forget about contributing to a regular IRA if they qualify for the Roth.)
As for your kids, a regular brokerage account set up with the kinds of stocks that you can keep for many, many years, like Rule Makers, could prove to be an excellent retirement vehicle. And the minute they start baby-sitting, count that cash! File an income tax return (they aren't likely to earn enough to trigger taxes) and you can contribute an amount equal to their earned income to a Roth IRA. Do be careful. Such a situation is ripe for a fiddle and Uncle Sam is probably very aware of that. 'Nuf said.
Fool on and prosper!