The math behind investing early in life is compelling. While the question remains open as to whether Albert Einstein called compound interest the eighth wonder of the world, its power is unquestionable. When we encounter time value of money issues in a retirement planning course, students are often surprised at the importance of saving money early in life.
Imagine that Lucia is 20 years old and invests $ 5,000 per year for ten years. On the other hand, Lucia’s friend Will starts investing the same amount at age 30 and continues for 35 years until retirement age. Who ends up with more money at 65, Lucia or Will?
If we assume an annual return of 7%, Lucia wins this competition. Compound returns are the force that gives Lucia the potential to make more money with $ 50,000 than Will with $ 175,000. The math is even more compelling if the investment begins at age 16, with just seven years of regular contributions exceeding Will and Lucia’s totals. Consider these options for young investors who have the time on their side.
Roth IRA: I have a twinkle in my eye every time I hear a client’s child working outside the house. This means the child has earned income, which means the child can most likely open a Roth IRA. With a Roth, your child can invest up to $ 6,000 per year or their earned income, whichever is less. The Roth is a type of account that you can hold at any major brokerage firm. Perhaps the most compelling attribute of a Roth is that it enables tax-free growth over the lifetime of the account owner.
While my preference is to let the Roth IRA grow and use the power of decades of portfolio growth, it is possible to access a Roth’s funds before retirement age. You can still withdraw your contributions to a Roth IRA (as opposed to income) at any age and for any purpose, without penalty or tax. There are also exceptions to withdrawing funds for higher education and buying a first home.
Custodian account: In Colorado, custody accounts are typically set up as a Uniform Transfer to Minors Act account, also known as a UTMA account. Minors under the age of 18 require that an adult be responsible for the deposit account. The custodian is responsible for making investment decisions as well as ensuring that all funds withdrawn from the account are used for the benefit of the minor. Although UTMA accounts are not tax exempt, the first $ 1,100 of income in a year is earned tax free, while the next $ 1,100 is taxed at the child’s tax rate. .
Although UTMA accounts do not have the same tax benefits as a Roth IRA, they do have the option of receiving deposits regardless of whether the minor has earned income or not. If your child receives a nice gift for the holidays, they can turn around and drop it directly into the UTMA regardless of their work situation. For some people, one of the downsides of a UTMA account is that the beneficiary in Colorado will be entitled to use the funds in the account for any reason at the age of 21. Additionally, if need-based financial aid is an option for a student, then a deposit account may affect their eligibility.
529 Education savings plan: If your child is planning to contribute to college, it’s hard to beat a 529 Education Savings Plan. With an Education Savings Plan, you have access to tax-free growth as long as the funds are ultimately available. used to pay for tuition, fees, room, board, a computer or supplies for a student. In Colorado, we have access to the Direct Portfolio plan with low cost investment options. While most 529 plans are funded by parents or other family members, a child can create their own 529 plan through a custody account. Usually, we recommend that parents do this, as they are generally in a better position to take advantage of the state tax deduction for the deposits they make into the plan.
David Gardner is a Certified Professional Financial Planner with Mercer Advisors and practices in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting or tax advice. They reflect the judgment of the author on the date of publication and are subject to change.