Here's a simple question that will endear you to your clients. Ask parents or grandparents of a teenager if the kid has a job. There is a good chance they will say “yes” — the Bureau of Labor Statistics says over 40 percent of high school students are employed outside the home. If they say “no” and then go into a rambling monologue about their shiftless, lazy, ungrateful teenager who doesn't appreciate the value of a dollar and, why, when they were teenagers, they held four jobs, got straight A's, and still had time to invent rock ‘n’ roll, nod agreeably and try to move on.
However, if the child is working, you have an opportunity to turn a few thousand dollars into a few million for your family's next generation and you can do it without paying taxes.
The vehicle of choice is the Roth IRA. Investment Company Institute surveys indicate there may be a couple hundred thousand Roth IRA owners under 18. But that will skyrocket as more parents and grandparents are shown the jaw-dropping power of several decades of compounding interest.
Say a 15-year-old works 10 hours a week at $6 per hour. She will earn about $3,000 per year, and can contribute the entire amount to a Roth IRA for 2002 (I know — “I can't get my kid to save money for 15 minutes, much less for 50 years!” — we'll get to that). If she also earns and contributes similar dollar amounts for the next two years, never puts in another penny, and the money grows at 10 percent annually, her $9,000 could turn into a whopping $1 million by the time she is 67.
Teens aren't known for their ability to deny themselves immediate gratification in exchange for long-term reward. No problem. It's perfectly legal for the kid to blow her earnings on Limp Bizkit CDs while the parents or grandparents make contributions to her Roth IRA, as long as the deposits don't exceed the lesser of her earnings, or the annual contribution limits. Keep an eye on the annual limits on gifting, too — a deposit into a child's Roth IRA counts toward the $11,000 limit one person can give to another without incurring the gift tax.
What About College?
Of course, if upcoming college costs are a concern, then money should be kept in more accessible vehicles. But that doesn't necessarily mean funds in a child's Roth IRA can't be tapped as a last resort. If the money is used for qualified education expenses and the funds were deposited at least five years before being taken out, withdrawals of earnings are penalty-free (but they are taxed as income). And deposits can always be withdrawn with no taxes or IRS penalties.
Also, many higher education institutions don't consider a student's Roth IRA when calculating the Expected Family Contribution for financial aid purposes.
Although Roth IRAs are popular with that tiny niche of clients who don't like paying taxes, you will find this proposal to be especially attractive to two desirable groups: business owners and high-income families. Business owners like it because they usually have the flexibility to employ their children or grandchildren in various tasks around the shop or office. Depending on their corporate status, the wages they pay their kids may reduce the business owner's state and federal income taxes, as well as Medicare and Social Security expenses.
And while income limits preclude high-salary individuals from opening Roth IRAs for themselves, their lower-income children still qualify. Shifting money from the parents to the kids in this manner will not only reduce the family's future tax bills, but down the road the contribution might also reduce the client's taxable estate.
Not every financial services company will let you open a Roth IRA for a minor and those that do may require clients to sign a waiver letter. But many companies are more than happy to help you get started, including Alliance Capital, American Century, American Funds, American Skandia, Franklin Templeton, Janus, Lord Abbett, Schwab, TIAA-CREF, Van Kampen and Vanguard.
‘We Need to Talk’
Once you've presented the idea, chosen an investment vehicle and are ready to fund the kid's Roth IRA, your service to your client's family shouldn't stop there. Three of the most difficult discussion topics for parents to bring up with their kids are sex, drugs and money. It's not your place to discuss the first two issues with your clients' progeny. But offering to sit down with a teen to discuss general financial principles will plant a seed of money wisdom, help you establish a relationship with a potential heir to your client's assets, and will put you one step closer to being known as the family's trusted advisor.
Our recommendations to our clients carry so much more weight when we can demonstrate our willingness to invest our own money in the same manner. So, if your child is earning a few bucks, by all means open a Roth IRA on her behalf.
If your child hasn't yet ventured into the working world, you can still kill two proverbial birds with one check by paying her to perform tasks around your office. Filing, cleaning, mailings — whatever: The basic requirements are that she is at least in her teens, her hours are documented and you pay her a reasonable wage. And who knows — making her a tax-free millionaire in retirement might give her a million more reasons to visit you in the nursing home.
Kevin McKinley is a CFP and vice president of investments at a regional brokerage, and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future. www.kevinmckinley.com