When it comes to giving thoughtful gifts, financial security may not be the first thing on your mind. However, giving a Roth IRA can be a meaningful way to start your loved ones on a path toward financial security.
A Roth IRA is a type of individual retirement account that offers tax-exempt growth and tax-exempt withdrawals in retirement, which make it a powerful tool for building long-term wealth. Contributions to Roth IRAs are made with after-tax dollars, and qualified withdrawals of assets are tax-exempt and don’t increase your taxable income. In contrast to traditional IRAs, they aren’t subject to required minimum distributions (RMDs) during the owner’s lifetime, which means assets in the account can continue growing tax-exempt throughout the account holder’s life.
There are several benefits to giving a Roth IRA.
1. Tax-Exempt Growth
One of the primary benefits of Roth IRAs is that they allow contributions to grow on a tax-exempt basis. This means any earnings, such as interest, dividends, and capital gains, aren’t subject to federal income taxes while held within the account. Over time, this can add up to significant savings, especially for younger investors who are able to let their assets grow over many years before withdrawing them in retirement.
2. Retirement Savings
Establishing a Roth IRA for a loved one can be a great way to help them save for retirement. Many young people struggle to find extra money to set aside for retirement planning. Funding a Roth IRA can help remove some of that financial burden and allow your family member to focus on other financial priorities, such as saving for a home, paying down student loan debt, starting a business, etc.
3. Financial Literacy
Giving a Roth IRA can be a great opportunity to educate loved ones on multiple financial topics, such as saving early and often, the power of compound interest, the basics of investing, and the importance of planning for retirement. With a Roth IRA, not only are you helping your loved ones financially, you’re also teaching important financial strategies.
4. Estate Planning
Not only are Roth IRAs not subject to RMDs during the account holder’s lifetime, but they can also be passed on to heirs tax-free following the account holder’s death. Roth IRAs are a tax-efficient way to transfer wealth to future generations because they allow heirs to receive assets without having to pay income taxes on the distributions (unless the Roth IRA is less than 5 years old).
In addition, Roth IRAs don’t count toward the taxable estate of the account holder, which means they can help reduce the size of an estate for tax purposes. By giving a Roth IRA as part of an estate planning strategy, the account holder has the potential to reduce their heirs’ estate tax liability, which helps preserve more assets for future generations.
5. Compound Interest
By giving a Roth IRA to a younger family member, you offer the opportunity to take advantage of compounding interest over the individual’s lifetime. The impact of this cannot be overstated.
Suppose you contribute $1,000 to a Roth IRA on behalf of your granddaughter every year, beginning at age 20. By the time she reaches 40, you would have invested $20,000 on her behalf ($1,000 x 20 years). Assuming an average annual return of 10 percent, the investment would be worth $63,773.40 after 20 years.
On the other hand, if your granddaughter began contributing $2,000 per year to a Roth IRA from age 30 to 40 ($20,000 total), her investment would only be worth $36,934.83 after 10 years (again assuming an annual average return of 10 percent) because she has less time to take advantage of the power of compounding.
Contributing to Roth IRAs should not exceed the amount actually earned in a year by the account owner — or the maximum contribution limit, if the owner earns more than that amount.
The gift of a Roth IRA to young family members has the potential to significantly improve their long-term financial outlook and be a cornerstone of their nest egg now and in the future. Roth IRAs can truly be the gift that keeps on giving.
Gene Gard, CFA, CFP, CFT-I, is a Partner and Private Wealth Manager with Creative Planning. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.
