Best Gift Idea? Be an Angel Investor

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Reprinted with permission from Inc.com.

I realize this isn’t going to make anyone’s Hot Gifts list, but if the notion of giving a child or grandchild a serious leg up on building financial security sounds appealing, the best gift this year–and any year–is to bankroll a Roth IRA for them.

Let’s face it, no teenager with a part-time job is thinking about retirement. Even 20-and 30-something adult children fully launched in their careers are often hard-pressed to commit to funneling precious after-tax income into some far off goal. But you and I both know, the earlier dollars are set aside, the more time there is for compounding to do its thing.

Though the kids aren’t chomping at the bit to use their own dollars to fund a Roth IRA, you can be their Roth IRA angel investor.

All that’s required is that the child has earned income that is equal to the amount you give them to contribute to a Roth IRA. So if a teen made $2,000 last year at a summer job, you could bankroll a $2,000 contribution to a Roth IRA. The 2013 maximum contribution for anyone under the age of 50 is $5,500. Just to be clear: The child would need to have at least $5,500 in earned income for you to be able to gift the full $5,500.

A quick back-of-the-envelope calculation: Gift $5,500 this year for a child or grandchild to use as a 2013 Roth IRA contribution and assuming a 6% annualized gain that’s going to be worth more than $56,000 in 40 years.

Make that $5,500 gift for five years (for a total gift of $27,500) and it could be worth more than $250,000 tax-free dollars in 40 years.

That puts a whole new spin on the notion of gift returns, eh?

A less taxing matter

The main allure of Roth IRAs is that money withdrawn in retirement is 100% tax-free. We’re not clear what our federal tax system is going to look like next year, let alone 40 years from now, but I can’t imagine tax-free income ever loses its appeal.

Now that said, there is a tradeoff at work here. While contributions to a traditional IRA are tax-deductible in the year they are made (assuming the individual meets certain income limits), Roth IRA contributions do not qualify for the upfront tax-break. But remember, withdrawals from the Traditional IRA will be taxed as ordinary income vs. no tax on the Roth IRA withdrawals.

The thing is, the upfront tax-break on the Traditional IRA isn’t likely to be worth much to your child or grandchild. It’s unlikely they have hit their prime earning years where they are in a high income tax bracket. Right now is when they are in their prime Roth IRA stage. They don’t need the negligible tax break on the Traditional IRA contributions. And they are probably well within the income limit for contributing to a Roth IRA.

Individuals with modified adjusted gross income below $112,000, and married couples filing a joint tax return with income below $178,000 can contribute the full $5,500 in 2013. (Note, anyone regardless of income can always contribute to a Traditional IRA and then convert that account to a Roth IRA. Just make sure you huddle up with your tax advisor, as there are a few IRS hurdles to deal with.)

One final gift idea: Encourage your child to invest the bulk of the Roth in stocks, rather than bonds. This is an investment that will not be touched for 40 or 50 years. Over that sort of stretch, the odds are extremely strong that a portfolio heavily weighted in stocks today will generate returns that provide much retirement security, to say nothing of a lasting legacy from you.

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Bill Harris

Bill Harris

Bill Harris is the founder and chairman of Personal Capital. He has spent 25 years building financial technology, notably serving as CEO of Intuit and PayPal. He is the founder of several financial technology companies and has served on the boards of numerous technology firms, such as SuccessFactors, RSA Security, Macromedia, and Answers.com.

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