The math behind investing in early life is compelling. Although the question is whether Albert Einstein called compound interest the eighth wonder of the world, its power is indisputable. When we go through time problems with money problems in the retirement planning class, students are often surprised by the importance of putting money away at an early age.
Imagine that Lucia is 20 years old and invests $ 5,000 a year for ten years. Lucia’s friend Will, on the other hand, starts investing the same amount at age 30 and continues for 35 years to the retirement age. Who ends up with more money at age 65, Lucia or Will?
Assuming an annual yield of 7%, Lucia wins this competition. Complex yields are a 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 starts at age 16, with just seven years of regular contributions beating both Will and Lucia. Consider these options for young investors who have time on their side.
Roth IRA: My eye especially blinks whenever I hear a client’s child working outside the home. This means that the child has earned income, which means that the child can most likely open up to the Roth IRA. With Roth, your child can invest up to $ 6,000 a year or their income, whichever is less. Roth is the kind of account you can have in any large brokerage house. Perhaps Roth’s strongest attribute is that it allows for tax-free growth over the life of the account holder.
While I want to allow the Roth IRA to grow and harness the power of decades of portfolio growth, it is possible to access funds at Roth before retirement age. You can always withdraw your contributions to the Roth IRA (as opposed to earnings) at any age for any purpose without penalties and taxes. There are exceptions to the withdrawal of funds for use in higher education and the first purchase of a house.
Custody account: In Colorado, custody accounts are usually set up as a single account under the Minor Transfer Act, also known as a UTMA account. Minors under the age of 18 require that an adult be held accountable for the custody investment 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 The custodian is responsible for making investment decisions as well as ensuring that all funds withdrawn from the account are used for the benefit of the minor.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 per year is earned tax-free, while the next $ 1,100 is taxed at the child’s rate.
Although UTMA accounts do not have the same tax advantages as the Roth IRA, they do have the flexibility of being able to receive deposits regardless of whether the minor has earned income or not. If your child gets a nice holiday gift, they can turn around and deposit it directly at UTMA regardless of their work situation. For some people, one disadvantage of a UTMA account is that a Colorado user will be entitled to use the funds in the account for any reason after they turn 21 years old. Also, if needs-based financial aid is possible for a student, then a custody account may diminish their eligibility.
529 savings plan at the faculty: If your child plans to contribute to their college education, it’s hard to beat the savings plan of 529 colleges. With a college savings plan, you have access to tax-free growth until the funds are eventually used to pay tuition, fees, rooms, meals, computers, or student supplies. In Colorado, we have access to a direct portfolio plan with cheap investment opportunities. While most 529 plans are funded by parents or other family members, a child can start their 529 plan through a custody account. We usually recommend parents to do this because they are usually in a better position to take advantage of the state income tax deduction for deposits they pay into the plan.
David Gardner is a certified financial planning expert at Mercer Advisors in Boulder County. The opinions expressed by the author are his and are not intended to serve as specific financial, accounting or tax advice. They reflect the judgment of the author on the day of publication and are subject to change.
