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The birth of a baby can lead parents to think about many things. That bundle of joy’s old age is probably not among them.Given the powerful nature of compounding interest — which ideally can double retirement savings every seven years — should parents be taking a greater role in securing their children’s financial future, not just by building a college savings fund, but by funding an IRA that can multiply assets for a lifetime to come?
Unfortunately, it’s not quite that easy. With people living longer and longer, the uncertainty of Social Security decades from now and the likely extinction of traditional pensions, future generations will need all the help they can get. A retirement plan that grows steadily as they age into adulthood could be exactly what they need to be secure and happy. Just $50 a month tucked aside in an IRA when a baby is born could grow to as much as $180,000 by the time they are 65 (assuming a 4% average rate of return).
A custodial IRA, established by a parent for their son or daughter, requires that the child have a source of income, at the very least a documented and taxable part-time job or summer employment, even if they will not be the one primarily funding it. Parents can try to count chore money and allowances as income, but the IRS could come knocking. Baby-sitting, lawn-mowing and snow-shoveling can count as income with documentation (so prepare to start handing out receipts to the neighbours).
Proof of income “is the first thing we need to satisfy before we can even go down that road,” says Brennan Miller, a specialist in family finance and financial consultant for Schwab’s(SCHW) Northbrook, Ill., branch. “But if the child does have earned income, there is a tremendous opportunity. Whether you are young or old, time is an investor’s and saver’s best friend. If you have the ability to bank on that compounding growth over long periods of time, especially when we are talking about teenagers, they could have this money growing for them for 40 or 50 years before they think about retiring. That could really end up providing them significant assets.”
Unless your toddler can wield a rake, you may need to fund a savings account or custodial brokerage account and mark time until that child gets that first job.
Miller cautions, however, that with an arrangement where an adult custodian manages the assets for the benefit of the minor, there are no tax benefits.
“Also, assets in custodial accounts are weighted more heavily when the child is applying for college financial aid,” he says. “Money in retirement accounts like a custodial IRA or custodial Roth IRA are excluded from those calculations because they are retirement assets, not assets that are typically used for educational purposes.”
Parents looking ahead to the retirement needs of their kids should consider a Roth IRA rather than a traditional IRA, says Chris Hobart, president of Hobart Financial Group.
With a Roth IRA, contributions are not tax deferred, as is the case with a traditional IRA, and earnings grow tax free with no assessment on distributions. With a traditional IRA, your kids would be required to pay taxes on your retirement gift to them, even at the time they need that money the most. Paying taxes upfront also hedges against the likely scenario tax rates will rise in the future.
“We work primarily with retirees, and they have built these tax time bombs that are now forcing them to take money out at age 70.5 and pay taxes on it,” he says. “If you can create a tax-free future benefit for those kids, you are not just saving for retirement, you are doing it in a totally tax-efficient manner.”
There are other, similar, vehicles a parent could choose to give their kids a head start on saving for retirement.
Business owners, for example, can start a 401(k) plan for their children, a vehicle that will allow even greater contributions than just IRAs or Roth IRAs.
“I’m not sure what work they do around the office, but the parent does pay them some sort of an income that allows them to build up retirement accounts at a more aggressive level,” Hobart says. “A lot of times, small-business owners will get their children working in the business because of [a retirement benefit],” Miller says. “Not only can you be putting money in a traditional or Roth IRA, but if you are a business owner paying your child a salary that’s also going to be reducing your taxable business income. It’s kind of a win-win, and the child gets to learn the business as well.”
Hobart suggests another option for parents.
“If you really want to think long term, planning for when your kids are 60 or 65 years old, the other concept you could look at is utilising life insurance,” he says. “That insurance also passes on as a tax-free benefit and typically you can use less money and get greater leverage. You insure mum and dad and because of that you don’t have limitations as to how much you can put in. You make your kids the beneficiaries, but the benefits are paid into a trust that might have restrictions on how and when they can use it. You can essentially create the same concept of a retirement plan for your kids … Unfortunately, if you live a long time, you might die when you are 95 years old and your kids are sitting there at 75 years old saying, ‘Gee, thanks, mum and dad.’ There could be trade-offs.”
With an IRA, even though parents serve as custodians the assets are still owned by the child, even if they are restricted from drawing from them as minors. The danger is that once they turn legal age that well-funded IRA could become just another bank account — or, more cynically, a winning lottery ticket — as far as they are concerned.
“Once they hit 18, that money is officially all theirs with no oversight to it,” Hobart says. “If they want to cash it in and pay a penalty on it, so be it. That’s the problem. You can try to hide that it exists from your kids, but there is this little thing called the law that says they have to know about it. As mum and dad you are the custodians of the fund and lording over that money, but once they turn the legal age all of that kind of goes away. You lose control right around the time of life where you probably don’t want them having all that money.”
What parents need to worry about, then, is the maturity — or lack thereof — their kids have when it comes to money. Even with modest assets, kids can have a “trust fund kid” mentality.
“You have to be sure that kids have a little bit of a buy-in,” Hobart says. “Otherwise there can be a sense of entitlement or laziness. [Even with just $5,000 a year] they might think they can live off it, and that’s just not reality … the wrong kid getting the wrong amount could hurt them.”
“I think the idea is good and given the right guidelines it can be powerful,” Hobart says of establishing a retirement account for kids. “I like the concept. I just fear human nature.”
Miller says a custodial IRA could help give kids “teachable moments” and “concrete examples of how this could really help them over the long haul.”
As they understand the power of saving and interest, there will hopefully be “light bulbs going off” and kids want to participate in these arrangements,” he says. Its up to parents to make sure they stay on the right track with the retirement funds they get.
“In most cases, a college-educated person goes through 16 years of education and yet they never have a personal finance class,” Miller says. “You finish school at age 21 and now you are taking over this IRA. If you don’t know that there could be penalties if you take money out, or how much you should have or be putting away — if you’ve never done that maths with a parent — you could just see it as a windfall to take advantage of and all those years of saving and compounding and growing could disappear with a couple of silly purchases.”
Also problematic can be how younger generations are reacting to recent financial setbacks and market volatility. Just because parents established an IRA is no guarantee their kids will keep funding it or manage it adequately.
Research released last week by T. Rowe Price(TROW) shows that “despite compelling evidence that younger investors are well-positioned to benefit from long-term retirement savings,” less than half (45%) of those considered Generations Y and X (ages 21-34 and 35-50 by its criteria) plan to contribute to an IRA during the 2011 tax season.
Most (55%) said they do not plan to fund an IRA, or are unsure whether they will do so for the 2011 tax filing season. By comparison, 71% of these investors made an IRA contribution for the 2010 tax year.
Among the rationales: a belief that current participation in a 401(k) plan is adequate for now (42%); feeling that they can’t afford it (32%); economic uncertainty (23%); market volatility (14%); and uncertainty (12%). When asked what they would do with an extra $5,000, most investors (56%) said they would pay off existing debt or add to a “rainy day” fund; only 16% said they would contribute to an IRA.
“Given their economic fears, it is understandable why many younger investors might be unable or unwilling to fund all of their tax-advantaged accounts and are focusing primarily on their 401(k) during this tax season,” says Stuart Ritter, senior financial planner for T. Rowe Price. “However, younger investors must remember that their investments may need to cover 30 years or more of living in retirement. They need to save consistently. There will always be some level of uncertainty and competing financial demands. The longer people wait, the more they will need to save later. Even if present circumstances cause an interruption in a retirement savings program, it’s important to re-start as soon as possible.”
Also affecting the investment habits of younger people is a loss of faith in stocks.
The study found that only 22% of Generation X and Generation Y investors feel confident about the financial markets heading into 2012. Among those who said they do plan to fund an IRA this tax season, 28% said they will direct their contributions to relatively stable investments, such as money-market funds. This is despite the historically low current yields being offered and what T. Rowe Price described as “their lack of suitability as long-term retirement investments.”
“Younger investors need to invest for growth,” Ritter says. “They shouldn’t focus on what the market did last year or what it might do this year. They are investing for decades and need to have an appropriate mix of stocks in their portfolios to have hope of achieving their long-term financial goals.”
— Written by Joe Mont in Boston.
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