Roth Counters Inertia
- Published: 08/29/2011
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Newton’s Law applies to human motivation as well as objects. William James, the father of American psychology, illustrated this relationship with following story. James was lying in bed on a cold winter morning. The bed was warm - the room, freezing. He lay on his back watching his breath fill the air with crystalline plumes of vapor and shuddered at the thought of walking barefoot across the room to rekindle the fire. He was comfortable and content under layers of blankets. Getting out of bed meant pain and discomfort. Minutes ticked away as James’ mind sifted reason after reason not to change its peaceful status. Suddenly, a greater realization brought him to his feet: The fire wasn’t going to start itself. No fire meant no breakfast. And besides, he had work to do.
We can all relate to James’ experience. It helps explains a variety of challenges such as why it is so hard to lose weight or to stop smoking. Like objects in motion we tend to maintain our direction – our habits of thought and action – until a greater force such as, for example, Doctors Orders, helps us realize the need for change.
Newton’s Law also explains why most of us avoid saving for retirement until the shadow of middle age - and sheer panic – finally spurs us to action. The result: we must save more to retire with less money than we would have if we had started saving when we were younger.
So, what does this have to do with taxes? If you’re a parent or grandparent this solution is a Roth IRA. A Roth IRA can be established for anyone, including children, who have “earned income” (from a job). Under current rules, qualifying individuals can place up to $5,000 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is allowed for Roth contributions (which wouldn’t benefit most kids anyway), interest compounds tax free and, if not withdrawn until age 59 ½, can be removed completely tax free. What impact could this have on your child’s future? Let’s consider at two common scenarios.
Jack is a typical 35 year old who suddenly realizes he is getting older. Jack scrimps and struggles 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, a fairly realistic assumption, Jack will have approximately $620,000 to retire on when he reaches age 65.
Jill, on the other hand, is a typical American in her early twenties – thoughts of retirement far, far away. But when Jill was very little, her parents decided to set aside $50 each month for Jill’s future. Then, when Jill started working part-time as a teenager, they established a Roth IRA in her name and began to move funds from the savings account to her Roth. By the time Jill was 20 years old, her Roth had a balance of $25,000, an amount that will continue to grow, tax free, until Jill is ready to retire. If Jill’s Roth earns the same average annual return as Jack’s, 8%, the $25,000 seed planted by her parents will be worth over $900,000 on her 65th birthday.
So, let’s recap.
- 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 out with $25,000, saves nothing, and ends up with 45% more money than Jack.
For the price of a car or a semester at many universities, Jill’s parents have used the Tax Code to give their child a gift of unspeakable value – a financially secure and tax-free retirement.