Helping Grandchildren Retire
- Published: 01/30/2014
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Sir Isaac Newton’s First Law of Motion states that an object at rest will remain at rest until an agent-of-change forces it to move. Once set in motion, the object will maintain the same speed and direction until something forces change again.
Newton’s Law and Human Nature: Newton’s Law applies to human motivation as well and can be summed up with the following fact: We humans tend to procrastinate! William James, the father of American psychology, illustrated his own Newtonian tendencies by sharing the following experience. James was lying in bed on a cold winter morning in the late 1800’s. His bed was warm but the room . . . freezing. He lay there on his back, looking at the ceiling as his breath filled the air with crystalline plumes of vapor. Comfortable and content under layers of blankets, he shuddered at the thought of getting out of bed, and the pain and discomfort of walking barefoot across the frozen floor to rekindle the fire. Minutes ticked away as James procrastinated – his mind counting reason after reason to remain warm and at rest.
Then, suddenly, a greater discomfort struck him: a pang from his stomach. James was very hungry! He was then struck by a second, nearly instantaneous, realization. The fire on the other side of the freezing floor couldn’t start itself. Without a fire there could be no breakfast! So, for James on that cold morning, hunger became the greater discomfort – that agent-of-change that forced him from his bed and onto the freezing floor.
We can all relate to James’ experience and its ability to explain why it is so hard to change: to lose weight or to stop smoking. We, like objects at rest, remain at rest – creatures comfortably resigned to habit – until a greater force, such as doctors’ orders, forces us to change our behavior.
Newton’s Law & Retirement: James’ observation also sheds light on an irksome financial mystery - why so many of us avoid saving for retirement until the shadow of middle age - and sheer panic – finally spur us to action. The consequence of this financial mystery is well documented. Those who wait must save tens-of thousands more to retire, and retire with less money, than if we had started saving earlier.
Grandchildren & the ROTH IRA: If you’re a grandparent, the Tax Code provides a solution that will remove this Newtonian-Savings dilemma from your grandchild’s future. One solution is a Roth Individual Retirement Account (IRA). A Roth IRA can be established for anyone, including children, who have “earned income” (from a job). Under current rules, qualifying individuals under age 50 can place up to $5,500 into a Roth each year. Although no tax deduction is allowed for Roth contributions (which wouldn’t benefit most kids anyway), interest compounds tax free and, if not withdrawn until age 59 ½, can be removed completely tax free. While your children struggle to save and pay for your grandchild’s college, consider giving your grandchild a gift that will help relieve a major future burden: using a ROTH to help save for retirement. What impact could this have on your grandchild’s future? Major. Let’s consider two common scenarios.
Jack the Normal Procrastinator: Jack is a typical 35-year-old who sees a few grey hairs and suddenly realizes he is getting older. Suddenly, Jack realizes he has not saved a single dime for retirement. Spurred onto action by sheer panic, Jack becomes an object in motion. He budgets, scrimps, and struggles, and manages to put $417 into a Roth IRA each and every month ($5,000 per year) for the next 30 years. In all, Jack places over $150,000 in his account. If his Roth earns an average of 8% per year (compounded monthly), a large but fairly realistic assumption, Jack will have approximately $620,000 to retire on when he reaches age 65.
Jill: Procrastinator with Awesome Grandparents: Jill is a typical American in her early twenties; thoughts of retirement are far, far away. When Jill was young, her grandparents decided to set aside $50 each month for her future. Then, when Jill started working part-time as a teenager, they established a Roth IRA in her name and, as she earned income, began moving funds from their savings to her Roth account. By the time Jill was 20 years old, her Roth IRA had a balance of $25,000, an amount that will continue to grow, tax free, until Jill is ready to retire.
The Power of Early Savings: Because of time and the power of compounding interest, Jill faces a more secure retirement than Jack, even if she does not save another dime for retirement. If Jill’s Roth IRA earns the same average annual return as Jack’s, 8% (compounded monthly to compare to Jack’s monthly payment, resulting in an 8.3% effective annual rate), the $25,000 seed planted by her grandparents will be worth over $900,000…. $250,000 more than scrimp-and-save Jack - on her 65th birthday!
Recapping the Power of Compounding Interest:
- Jack starts saving when he is 35 years old. He saves $5,000 each year for 30 years, over $150,000 in total, and accumulates $620,000 for retirement.
- Jill starts her IRA savings with $25,000 that her grandparents placed in her Roth IRA when she was 20. She saves nothing more for retirement and ends up with $900,000, 45% more money than Jack.
For the price of a car or a semester at many universities, Jill’s grandparents have used the Tax Code to give their child a gift of priceless value – a financially secure and tax-free retirement.
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