Starting a Roth IRA for Kids in HNW Families
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Table of Contents
Why a Roth IRA for Kids?
The Power of Compounding
Matching Contributions
Taxable Brokerage Accounts
Index Funds vs. Stock Picking
Considerations for High-Net-Worth Families
Educational Savings Accounts for Kids
Starting a Roth IRA for Kids
While traditional savings accounts and investment vehicles can be beneficial, high-net-worth families face unique challenges when planning for their children’s financial futures.
A Roth IRA for kids is one effective plan to maximize retirement savings long-term. When selecting the best savings account for kids in high-net-worth individuals, parents will want to consider not only investment options but also how to best teach financial literacy.
Why a Roth IRA for Kids?
Roth IRAs are a popular option for families seeking to provide their children with a solid financial foundation. Unlike traditional savings accounts, Roth IRAs are investment vehicles designed for long-term growth, making them an excellent choice for high-net-worth families who can afford to let the funds grow over time without immediate access.
As of 2024, the Roth IRA contribution limit is $7,000 per year or the amount of earned income, whichever is less. Additionally, the annual gift tax exclusion has increased to $18,000 per donor per recipient for 2024.
To open a Roth IRA for kids, the child must have earned income. This can come from a variety of sources, including part-time jobs, such as babysitting or working in a family business. However, parents cannot simply give their children money to put into a Roth IRA; the contributions must come from the child’s earnings.
Some high-net-worth families find creative ways to structure earned income for their children, such as paying their children for tasks such as working in the family’s real estate office. This is an acceptable strategy as long as the work is age-appropriate and the pay is reasonable for the tasks performed. Still, parents looking to open Roth IRAs for their children should be cautious not to exploit loopholes, such as paying their children for tasks like mowing the lawn or cleaning their room, which could invite scrutiny from tax authorities.
Regardless of the income source, it is crucial to maintain accurate records of earned income and contributions, especially when employing children in family businesses, to ensure compliance with IRS regulations.
Once a Roth IRA account is set up, the next question is how to structure investments. Low-cost index funds are a great choice for Roth IRAs, especially for long-term growth. Vanguard's Total Stock Market Index Fund (VTSAX) and the S&P 500 ETF (VOO) are also popular choices since they offer broad market exposure with low fees. While it may be tempting to let children pick individual stocks, it is often better to start with a diversified index fund that minimizes risk while allowing the account to grow steadily over time.
While some investors express concern about investing in ETFs at market highs, historical data shows that markets are often near all-time highs. Many financial experts emphasize the importance of “time in the market” rather than trying to “time the market,” especially for long-term investments like children's Roth IRAs.
For families seeking more investment flexibility, self-directed IRAs are another option. These accounts allow for a broader range of investment choices, including real estate and private equity. However, they require more hands-on management and a deeper understanding of various asset classes.
The Power of Compounding
Roth IRAs for kids are particularly appealing because of the potential for decades of compounding growth. The money in a Roth IRA grows tax-free, and withdrawals in retirement are also tax-free. This means that even small contributions made during a child's teenage years can grow into a substantial nest egg by the time they reach retirement age.
For example, if a 16-year-old contributes $6,000 per year to a Roth IRA for just five years, and the account grows at an average annual rate of 7%, they could have over $500,000 by the time they turn 65.
Roth IRAs offer unique tax advantages for children. Contributions are made with after-tax dollars at the child's typically low tax rate, and the growth and qualified withdrawals in retirement are tax-free. This tax arbitrage can significantly boost long-term wealth accumulation.
Matching Contributions
Some high-net-worth families use matching contributions to encourage their children to save. For instance, parents could offer a 2:1 match, where for every dollar their child contributes to the Roth IRA, the parent contributes two dollars. This approach not only incentivizes children to save but also teaches them about the importance of investing for the future.
High-Net-Worth Income & Spending Report
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Taxable Brokerage Accounts
While Roth IRAs are a powerful tool, they come with restrictions, namely the need for earned income and the inability to withdraw contributions before retirement without penalties. For families seeking more flexibility, taxable brokerage accounts can be a great alternative.
Custodial brokerage accounts—often structured as UTMA (Uniform Transfers to Minors Act) or UGMA (Uniform Gifts to Minors Act) accounts—allow children to hold stocks, bonds, and other securities until they reach the age of majority, at which point they gain control of the account.
Parents serve as custodians of these accounts until the child reaches the age of majority (usually 18 or 21, depending on the state). It's important to consider the implications of transferring control to the child at this age and to prepare them for the responsibility of managing these assets.
One benefit of custodial accounts is that they can be funded with gifted money, unlike Roth IRAs, which require earned income. Parents can contribute up to the annual gift tax exclusion limit ($17,000 per parent per child in 2023) without triggering gift taxes. This allows high-net-worth families to transfer significant wealth to their children over time while still maintaining control of the investments until the child comes of age.
Additionally, some parents use these accounts as educational tools, allowing their children to make investment decisions and track their performance. Parents might give their child a share of stock for birthdays or holidays, serving as both a financial gift and an opportunity to teach the child about investing. Over time, this approach helps children develop financial literacy and an understanding of stock markets.
Index Funds vs. Stock Picking
When it comes to choosing investments for children’s accounts, parents are often torn between index funds and stock picking. While index funds offer broad market exposure with minimal fees, some parents allow their children to experiment with individual stock picks.
One strategy is to allow a child to pick one stock each year as a way of getting them involved in the investment process. This approach can also help reduce the number of unnecessary toys and gifts, as the child might look forward to selecting their stock instead of focusing on material goods. While this may not be the optimal strategy for maximizing returns, it serves as a valuable educational tool, helping children learn about markets, companies, and the concept of ownership.
For those who prefer a more hands-off approach, broad index funds like Vanguard’s Total Stock Market Index Fund (VTSAX) or SPY, the S&P 500 ETF, are strong choices. These funds provide exposure to a wide range of companies, reducing risk while still offering the potential for growth over time. With low fees and broad diversification, index funds are a staple in many high-net-worth families’ investment strategies.
Consider including funds with international exposure, such as Vanguard's Total International Stock Index Fund (VTIAX), to provide global diversification in a child's portfolio.
Market conditions continue to fluctuate, leading some investors to consider more defensive strategies. While the broad consensus on favoring low-cost index funds remains valid, families may want to discuss with their financial advisors whether adjusting their children's investment mix to include more stable assets is appropriate given current economic uncertainties.
Considerations for High-Net-Worth Families
For high-net-worth families, it is important to balance the desire to provide financial security for children with the goal of teaching them responsibility. Some families choose not to give their children access to large sums of money early in life, instead focusing on teaching financial literacy and delaying wealth transfers until the children are older.
Some HNW parents do invest in Roth IRAs and brokerage accounts for their children but do not disclose the full extent of the accounts to their children. This approach ensures that the children do not develop a sense of entitlement and instead learn the value of hard work and delayed gratification.
Others choose not to maximize their children's Roth IRAs or make large gifts, encouraging their children to create their own wealth rather than relying on inherited money.
As children grow and financial markets evolve, it is important to regularly review and rebalance their investment portfolios. This ensures that the asset allocation remains appropriate for their age and risk tolerance and takes advantage of changing market conditions.
Educational Savings Accounts for Kids
High-net-worth families should also consider establishing plans to save money for their children’s education. As with all savings plans, starting when the child is young allows the most money to accumulate.
A 529 plan is a tax-advantaged investment account for putting away money for educational expenses. Deciding how much to invest in a 529 plan can be tricky; families need to weigh factors such as their investment timeline, risk tolerance, tax considerations, and anticipated educational costs. Those who are worried about overfunding a 529 plan might consider alternatives such as taxable brokerage accounts or U.S. Treasury bonds.
Starting a Roth IRA for Kids
Whether through Roth IRAs, taxable brokerage accounts, or matching contributions, the key to saving for children in high-net-worth families is to instill financial literacy and responsibility while providing a foundation for long-term financial security.
It is worth noting that Roth IRA funds can be used for qualified education expenses or first-time home purchases without incurring penalties, providing additional flexibility for the child's future financial needs.
By carefully selecting the right investment accounts for kids and teaching children the value of saving and investing, high-net-worth families can ensure that their children are well-prepared for the future, both financially and personally.
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