The math behind investing early in life is compelling. While it’s an open question whether Albert Einstein called compound interest the eighth wonder of the world, its power is indisputable. When we run through time value of money problems in retirement planning class, students are often surprised about the importance of putting money away early in life.
Imagine Lucia is 20 and invests $5,000 a year for ten years. On the other hand, Lucia’s friend Will starts investing the same amount at 30 and continues for 35 years until retirement age. Who ends up with more money at age 65, Lucia or Will?
If we assume a 7% annual return, Lucia wins this competition. Compound returns are the force that gives Lucia the potential to create more money with $50,000 than Will does with $175,000. The math is even more compelling if the investing begins at age 16, with only seven years of regular contributions beating both Will’s and Lucia’s totals. Consider these options for young investors who have time on their side.
Roth IRA: I get a special twinkle in my eye whenever I hear that a client’s child is working outside the home. It means that 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 a 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 single most compelling attribute of a Roth is that it permits tax-free growth over the life 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 the funds in a Roth before retirement age. You always can pull out your contributions to a Roth IRA (as opposed to earnings) at any age for any purpose without penalty or tax. There are also exceptions to pulling out funds for use for higher education and a first-time home purchase.
Custodial account: In Colorado, custodial accounts are usually set up as a Uniform Transfer to Minors Act account otherwise known as a UTMA account. Minors under 18 require an adult to be responsible for the custodial investment account. The custodian is responsible for making the investment decisions as well as for ensuring that any funds taken out of the account are used for the minor’s benefit. While UTMA accounts are not tax free, 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.
While UTMA accounts do not have the same tax advantages as a Roth IRA, they do have the flexibility of being able to receive deposits whether the minor has earned income or not. If your child receives a nice gift for the holidays, they can turn around and deposit them directly into the UTMA regardless of their work situation. For some people, one downside of a UTMA account is that the beneficiary in Colorado will have the right to use the funds in the account for any reason upon turning 21. Also, if need-based financial aid is a possibility for a student, then a custodial account can impair their eligibility.
529 college savings plan: If your child is planning to contribute to their college education, it’s hard to beat a 529 college savings plan. With a college savings plan, you have access to tax-free growth as long as the funds are ultimately used to pay for tuition, fees, room, board, a computer or supplies for a college 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 start their own 529 plan through a custodial account. Usually, we recommend that parents do this as they are usually in a better position to take advantage of the state income tax deduction for deposits they make into the plan.
David Gardner is a certified financial planner professional at Mercer Advisors practicing 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 as of the date of publication and are subject to change.