[Editor's Note: This is a guest post from Glenn Frank, CPA/PFS, MS (Taxation) who has submitted a guest post previously and has previously purchased advertising on The White Coat Investor. He owns Frank Advising, which analyzes the tax side of a portfolio for a quoted fee, and is a professor in the financial planning program at Bentley University. Enjoy the post. I'm curious to hear the comments on this one.]
How Will Our Children Survive? Our 50/50 Plan
Are you worried that social “insecurity” benefits and defined contribution plans will not sustain your children through their 30+ years in retirement? Will they save adequately? Will they invest prudently?
Our solution for their “survival” cash flow follows: First I have copied an email my wife and I sent to Cameron, our 20 year old. Secondly, I'll discuss the plan behind the email and how we hope that gifts of $50,000 per child will generate $50,000 per year of tax-free income during their golden years.
Professor Glenn Frank
The Email
Cameron,
A ROTH IRA is an account that you can contribute up to the greater of $5,500 or your reported wages on your tax return for the year. The tax-free accumulations can be tremendous, assuming the funds are wisely invested over time. Retirement withdrawals are tax-free (there are penalties for early withdrawals). Per Einstein, “The greatest force on earth is compound interest.”
For example, using the rule of 72 – if your average return is 7% (72 divided by 7 = 10) then money doubles roughly every 10 years. A $1,000 contribution would be worth $2,000 by 2024, $4,000 by 2034, $8,000 by 2044, $16,000 by 2054 and $32,000 by 2064 (you would be about 70 by then). Imagine what larger contributions for more years can amount to!
We know it seems wild to think about your retirement now but it is never too early. The benefit along the way is the great feeling associated with financial security + at a relatively young age you may have accumulated enough to make your then current passion “affordable”.
We are committed to at least 1 full year of $5,500 to get you started. We will provide guidance on how to invest the money but it will be your decision. Note this is intended to be “untouchable” until you retire although it will be legally yours – the “honor system” will apply.
In essence, this is inheritance we are funding now due to incredible tax benefits and to get you thinking about the future.
Love,
Mom and Dad
Our Plan
A current investment decision should force an initial discussion about investing/saving. Annual contributions should spur annual discussions. They will need to be convincing to alter our proposed portfolio of 3 ETFs (all US Equity, all International Equity and Frontier markets). They will realize that any imprudence on their part may negate future contributions – that there is a difference between long-term investing versus short-term speculation!
Our tentative plan is to contribute roughly $50,000 in total for each child over the next 10 years (if not a ROTH maybe via their 401k –matching the company match on their contribution – we will see what their tax brackets are and whether a ROTH is best).
For Cameron – by age 30 at 7% he should have about $70,000 ($5,000/year + earnings) in his ROTH. By 40 it would double to $140,000, by age 50 this will amount to $280,000 and by 60 $560,000.
Alternatively these funds could have been kept under our control in our taxable account over the next 40 years (we are 60) which they would inherit when we die at an assumed age of 100 (yoga/luminosity/veggies…) Assuming an annual tax bite of 2%, our annual net return would be 5%. At this rate, money only doubles every 15 years (72 divided by 5). If we start at the same $70,000 in 10 years (a simplifying assumption) at Cam’s age 30, the first doubling to $140,000 is not reached until he turns 45 and $280,000 is not reached until he is 60. The price of ongoing tax is 1 less doubling. Cam would inherit only $280,000 in a taxable account versus $560,000 in a tax-free ROTH.
Note that under the “keep it under our control” scenario we could have invested in buy and hold equities paying something less than 2% per year in taxes (taxes on dividends and rebalancing still add up) and they would get a step-up in basis to mitigate tax on appreciation. We thought it critical however, to have an investment program actually under their control. The idea is to compound $ and compound their financial education!
The rest of the plan – Cam still has another 10 years to work and even though we check out at age 100 his ROTH doesn’t. The $560,000 grows to $1,120,000 by age 70. With an annual drawdown rate of 4.5% our $50,000 contribution, generates $50,000 per year during those twilight decades.
Don’t grimace at your child’s first W2 – open up a ROTH!
Notes: Sustainable retirement drawdown rates of between 4 to 5% are often quoted in our industry. With inflation at 2%, prices will more than double by the retirement date. Perhaps the title should be “Our 50/25 Plan” given the reduced purchasing power. If 2% is low for inflation, hopefully 7% is low for a return assumption. In any case, the spread between the two, seems reasonable to us.
[Editor's Note: Mr. Frank's plan is the basic “daddy match” plan that has been advocated in various places. For example, teenagers with a job can put 100% of their earnings (up to $5500) into a Roth IRA (and beyond that into a taxable account) if daddy provides a 100% match for them to spend. They get their cake and can eat it too. If you wish to start retirement savings for your children prior to them earning any money, you can use a low-cost variable annuity as advocated in the book Make Your Kid A Millionaire. The decades of tax-protected growth should outweigh the additional costs of the VA. These are far better plans than buying them a stupid whole life policy which many people are suckered into doing. I also love Mr. Frank's plan to both provide an inheritance early (when it is more useful) as well as providing the more valuable inheritance of financial knowledge. The plan also displays the value of multi-generational financial planning when the family is not dysfunctional. Imagine if that Roth IRA that dad funded was left to kid's great grandkid and stretched over another 80 years. There could be 160 years of tax-free growth.
However, while reading his post I am struck by the dilemma of paying for your children's retirement. The Millionaire Next Door was very clear about the true cost of providing “Economic Outpatient Care.” Will the additional money provided to a 20 year old sap his motivation to really go for it career-wise and savings-wise? Whose job is it really to save for retirement? What would you say if your parents came to you and offered to give you retirement money? At this point in my life, I'd tell them to buzz off and go spend it on a cruise. At 20 with a negative net worth? Perhaps I would have taken a different tone. Despite my best efforts encouraging them to spend their nest egg, I expect I'll probably still get an inheritance, and it would have been far more useful at 20 than 60.]
What do you think of the “daddy match” program? How much of your children's inheritance will you be giving prior to death? What do you do to instill good financial habits in your children? Comment below!
I’m very much planning on a daddy match program. Start compounding early and throw in an investing education too. I think it would be good to go through a market cycle or two with the kids before they are on their own.
Reminds me of driving on a permit in Alaska. You get your permit at 14 there, then drive with your parents through two winters before getting your own license.
We put $1k into a custodial Etrade account on every birthday (we have a 2 year old and one on the way). I purchase various mutual funds and few single stocks based on their age and consumer habits (Disney this year). It is meant to be more educational vs funding retirement as the transactions fees (although kept to a minimum) cut into returns. I do like this idea from Frank and think so long as it is focused around education vs hand-outs it’s a great process… – Jon
Does having ROTH IRA or money of their own affect their ability to get financial aid in College?
From what I have read, it does not have to be reported on the FAFSA. I have also read, however, that some schools individually will take the account into consideration when determining the students ability to pay. Nevertheless, it would seem that someone who is able to fund an IRA for their child is not going to qualify much for government aid/student loans.
Here’s a link to a pretty good article from Forbes on the subject: http://www.forbes.com/sites/troyonink/2014/02/14/how-assets-hurt-college-aid-eligibility-on-fafsa-and-css-profile/
My read on this is that aggressive savers will likely get no need-based aid for college. Anyone have a different experience?
I can come up with a scenario where you can minimize what goes on the FAFSA (stop working, put all assets into life insurance and retirement accounts). But keep in mind what most need-based aid is….it’s loans. That’s hardly worth rearranging my financial life to get.
Taxable accounts do, but Roths and other retirement accounts don’t.
Opened Roths for my three kids at age 12 0r so and maxed out every yr since
ALL INVESTED IN TOTAL STOCK MKT with vanguard
Guaranteed to have a nice sum after 55 yrs of compounding
Ken,
How are you legally “maxing” out a 12 year olds Roth IRA. I have trouble believing that your 12 year old has a job producing $5,500 worth of income every year.
WCI: if the IRS audits situations like this where is the line drawn? I have trouble believing the IRS is ok with me paying my child $5,500 a year to clean their room and mow the lawn.
Glenn: Same question. Does you 20 year old have a job producing $5,500? I would assume he is in college and maybe he does make that much with work in school/summer, but many 20 year olds do not.
Where are you all generating this income for your kids from??? I would love to start putting 5,500 into a roth for my 3 year old.
Thanks,
I’ve thought about adding my kids to the rolls of WCI as models, then paying them as independent contractors. They would then pay federal and state income taxes and both halves of the payroll taxes and put all the earnings into a Roth. It’s legal as near as I can tell. As long as the rates paid are reasonable for the work done, it is legal. You can hire your kid to work in your medical practice answering phones, but I probably wouldn’t try to convince the IRS your 3 year old is your receptionist.
No, it’s actually not guaranteed, even if it is likely.
Being in business allows you to put your kids on the payroll and use that earned income to fund their roth ira
I use a slightly different plan for my adult (working) children with the same goal. Encourage them to take advantage of workplace plans at least to the matching contribution and offer to match their Roth contributions dollar for dollar up to the maximum. I think it is important for them to have a direct financial stake in the Roth.
The Roth IRA for kids is a reasonably good idea with the daddy match but the VA is probably not. Besides the additional costs, you are changing long term capital gains into income tax rates. You also can’t tax loss harvest. Just better to go taxable after the Roth. Besides, they likely will need money (for house) before retirement. If one puts aside a lot of money for their kids then they shouldn’t be disappointed that the child isn’t as eager to work. Frankly if your economic situation is all taken care of then probably you should try to enjoy life without focusing so much on making money. Just need to be careful with that balance. I pay for educational activities but have no plans of helping my children retire. That isn’t necessary the right decision, just what I plan to do.
But over 60 years, the deferred tax more than makes up for the change from LTCG to regular income. Obviously a Roth is better if you qualify, but if you don’t, a low-cost VA can work out better than a taxable account. Plus the kid may get some asset protection out of it.
I don’t doubt that multiple decades can overcome the tax treatment however it isn’t just long term capital vs income rates. One also has to consider no tax loss harvesting, that you can’t easily access the money until retirement, and the extra costs associated with a VA. I’m not into this use the baby as a model. I find that too much so id say you could do this with a teenager and thus that’s at least a decade less of time. When you consider that one will first do the Roth for the kid, one should also consider the much greater chance they will need this money before retirement. That isn’t a trivial issue. If one wants to further favor the VA, then that happens with a very tax inefficient asset like REITs. If one wants to further favor the taxable then individual stocks that don’t pay dividends like BRK. This would be much riskier over a broad index fund but given one could make the rest of their portfolio well diversified, it might be worth it to some. It would to me since I believe the chance of needing the money before 59.5 to be high.
A Roth is obviously better, but you need earned income, so that usually means teenage years at a minimum. So the comparison is really a VA vs an UGMA. I favor an UGMA for non-educational money they need in their 20s (car, wedding, downpayment, honeymoon etc) and a low-cost VA for money earmarked for their retirement. Tax loss harvesting has a very minor effect unless the gain is never realized by donating the shares to charity or getting the step-up in basis at death. Obviously the less tax-efficient the asset and the more you value the asset protection (available only in some states) the better the VA comes out too. But the key is the decades of deferment. You’re not going to come out ahead in the VA with just 10-20 years. Nor will you come out ahead unless it’s a very low cost VA with the same investments you would use in a taxable account.
Now, whether you should contribute money toward your kid’s retirement or not is an entirely different question. I think the daddy-match program is superior to the “here’s a free VA” program any day of the week. But if you really want to start early….
Like communism, in theory this is a great idea.
I am very nervous about outpatient economic care. This can have the potential to backfire allowing the 20 year old to not live below their means.
To make this work, you need to have the right kid with the right personal finance education and disposition prior to any cash giving. This plan may work for some.
I plan to do the opposite and let my kids know that I plan to die broke and there will be no inheritance. It is a lie that I hope will keep them motivated.
I like the “lie” but I wouldn’t wait until you die to give the money. Too often people do worse with a large lump sum. Additionally if you give some while alive, you can “enjoy” the experience.
It doesn’t have to be a lie. You can give it to charity.
Agree with giving to charity. If we can make our own way, so can our kids. Sends a excellent message.
Hard to balance the message with our desire to actually help them avoid what we went through (student loans etc), isn’t it?
when I started the max to a roth was 2k I think
that was 15-20yrs ago
gotta wait till the kid is a teenager
chores around the house or cutting lawns, snow shoveling, and job in your office
its LEGAL
If they’re truly hired (and are paying taxes including payroll taxes on the income) then it’s earned income and can go into the Roth, even if you’re the employer. Don’t forget to pay your half of the payroll taxes.
My grandfather provided a nice lump sum of money to all of his grandchildren (30 or so) at a young age which included guidance in how he expected that it be used. It’s been very interesting to see how each of the grandchildren have spent/saved the money over the years (most received the money when they were in their teens). Some have used it for school, others for houses, others to spend more lavishly than they can afford, but most have continued to save it. I would dare guess that the financial decisions are no different with the money as they would have been without the money. Those that are responsible and have saved/used for schooling, saving, etc, would have been responsible with or without it. However, those that have “blown” it would be in a similar financial situation either way as well. I have found it extremely beneficial in helping me avoid debt and get a jump start on retirement savings which has helped me feel much more secure than if I didn’t have it. I definitely have appreciated the “jump start” and am preparing to do the same for my kids.
I think the daddy match into a Roth IRA is a fantastic way to do it. It allows the you/your kids to take advantager of their low tax bracket in their youth which becomes extremely valuable as a tax free account later in life, especially if they end up in a high tax bracket later.
I started a daddy-match Roth for my adult daughter a few years ago, when I found myself in the financial position to do so. At the time, she was working on-and-off during the Great Recession, and unable to do more than barely make ends meet, if that. I have used the Roth as a case study to teach her the rudiments of financial management, which she will be doing on her own eventually. However, she fortunately got a permanent job last year that put her over the income limit for further Roth contributions, but she can afford to contribute to her company’s 401(k). In its place, I have made her the beneficiary of my own Roths, which I began years ago. I am supplementing them with regular small conversions from my own Traditional IRA, thus building up the Roth component of my own retirement funds, keeping each annual conversion small to stay in a low tax bracket. In effect, I am building her a trust fund, the proceeds of which will be tax-free to her for many years under current law. Of course, this strategy also leaves open the option of tapping the Roths myself if ever needed.
You didn’t bother telling her about the backdoor Roth?
I truly have never understood why there is an income limit on a Roth.
One of my big beefs in the US tax system is an unequal benefits system.
I understand the need for a progressive tax system (personally I think it needs a few more tax brackets, a top level of 35%, and to tax most if not all income equally, but I digress).
However, if we are going to ask those that make more to pay more they should still get the same benefits.
– Why can only those under a certain income put $5,500 aside?
– Why do we have child tax credits but only for those under a certain income? Do we really want policies in place that “encourage or reward” the poorer population to have more kids but dissuade the richer? Seems kinda backwards.
– Oh and while I am on my bandwagon. Why do we give adoption tax credits to children born outside the US? How does it benefit tax payers? If you are taking a child out off the books in the US, then sure, lets help you out. However if you want a cute little Guatemalan around the house I don’t see why my tax dollars should help you fund it.
Politics is what it is called when there is no right answer and many different opinions.
So how do I safely give my 5 and 2 year old earned income when he cant work anything? What are my options, how much can I give, lets says being a mommy helper is worth how much an hour, and how much an hour a week can you give?
What are other options for this age group
I don’t think I’d try to claim “mommy helper” but you might be able to pull something like modeling fees out if you have their pics all over your office. Otherwise, better wait until they’re a teenager and you can convince the IRS they’re actually doing some useful work. You really want to get audited over a few hundred bucks in a Roth? If so, put down “mommy helper” at the bottom of your three year old’s 1040.
I have also thought about using toilet training money….Lollipops worked perfectly for potty training starting at age 2 and even though he has been fully potty trained for a year now, he still expects a lollipop every time he takes a poop. He would be rich if I paid him 10 bucks per poop into a Roth but somehow I don’t think the IRS would like this. I had never thought about modeling fees….That’s not a bad idea, since my kid is gorgeous! 😉
Hmmm…Economic Outpatient Lollipops. You’ve ruined his bowel habits for life.
The financial realities of life in America at present is that one can no longer be certain that your kids and grandkids will be have a realistic chance to be in the middle class just by being responsible and hard-working.
A primary reason for this is the growing correlation between high-dollar educations and high-dollar incomes, but tax policy likewise is stacked against the middle and upper-middle class earners.
Regardless of the reason, increasingly young people need both a bit of a leg up AND hard work to get into and stay in the middle class.
I personally believe that families need to have some sort of strategy to pass down modest amounts of money so their hard-working descendents will have a shot at the middle class dream. Doctors don’t need to worry about “ruining” their kids and grandkids. We don’t make enough to leave amounts large enough to do that — they are going to have to work.
I like the idea of the Christmas Day trust, where all of your descendents get a modest shot of money once a year. I haven’t set one up, but I am thinking about it.
The only leg up most hardworking young people need is the ability to finish their education without being a six figure amount in the hole. If we could fix that, I think that would get us 95% of the way there.
I’m employed and max out 457, 401a and 403b
Spouse 401k maxes out
I have around 25-40k/yr in 1099 moonlighting income
I setup a sep ira in 2013 but could only fund 5600
My question is it better to fund the sep ira for 3500-6000k/yr
or do a backdoor roth ira of 5500 for myself and wife each year?
If so, will I need to liquidate my existing sep ira to start doing the backdoor roth ira?
You don’t need to liquidate the SEP, either convert it or roll it into the 403B. Then use an individual 401(k) going forward for the $3500-6000/year AND do a backdoor Roth for you and your wife. Now, if you’re in an either/or situation, I’d need more info to give you the right answer. The Roth vs tax-deferred question is always complicated. But it’s easy when you can do both!
I think the “daddy match” idea could be extremely beneficial. Our children need mentoring in all aspects of life, not the least of which is finance. Participating in a program initiated by their parents can be just the apprenticeship they need for learning proper financial management.
And why not give them the “keys to the kingdom” while you are alive? If you have taught them well, they will do just the right things with the family jewels.
thanks WCI for this interesting posting.
please clarify these 2 questions for me:
1) I can not open a Roth IRA for my 4 years old boy unless he is “working”, for example as modeling fees for pictures etc.?
2) why can I open a roth IRA (through the back door) to my wife if she is not “working” (earning a salary)?
thanks
Look man, I don’t write the laws, I just tell you what they are. Ask Congress. They allow spousal IRAs, but not child IRAs. There are no girlfriend IRAs either.
I wonder how many people give $14K to their children when they are alive rather than leave it in their will.
I am thinking of doing this for my 11 year old daughter since I am and older parent and waiting until she is a fully grown adult might be too late for me. What are some good growth stocks /funds that I can invest in so that the value appreciates while minimizing the actual income received so that her tax burden is low.
not discouraging you, but if you just put the same money in a different account and then pass it to her after death then all the growth will be tax free due to step us basis. Plus what difference will you make, you will anyway end up paying for what ever she wants.
Muni bond funds and stock index funds are inherently tax efficient and can be used for a widely diversified, low cost portfolio. But until you get a portfolio of more than ~$100K for her, the taxes aren’t a big deal as they are either untaxed or taxed at her rate. If you pick something really tax-efficient (muni funds plus BRK for instance) it may never kick off any taxable income at all.
At 33 and expecting my first child, I haven’t yet faced the questions of “Economic Outpatient Care” outlined above, but it appears that Frank and his wife have timed their plan in a way that may help avoid disinsentivizing their son. 1) At 20, they have an idea of his work ethic and motivation. 2) He is old enough to learn about personal finance, investing, etc. through this exercise. 3) He will be well into his career before his Roth accumulates a balance large enough to induce him to slack. A large cash gift now or the direct annual financial support that some parents bequeath to their children might have a more negative effect.
What additional information do you need?
Our total household income is just under 600k
Live in a state with no income tax
Mid 30’s
Start with the info in this post:
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
There is so much that goes in to this decision including amount of assets, anticipated retirement date, amount of assets expected at retirement, amount being saved each year, concerns about asset protection and future tax rates, concern about future law changes etc etc.
The only general rules are everyone ought to have some of both types of assets, residents should use a Roth, and attendings in their peak earnings years should maximize deferment. Even those have exceptions.
I’ve wondered this conundrum often. It stuck out to me in the “Millionaire Next Door” and for the most part I believe its true. While pop culture doesn’t often relate to reality, you see very few children of the rich that have become successful on their own. They may be rich as well but largely through the money of their parents (or sadly reality TV).
I fund a little each month to my kids college accounts. Wish it could be more. I fully plan to fund the first year of a ROTH to get them started after college. If I am doing very well financially then I will consider going beyond that but I know the reality as well. I will be closing on 50 when my first is in college and retirement will be moving from the back of my mind to the front. My wife and I love to travel and I am unwilling to sacrifice our plans to ensure my children have a better retirement.
How much is to much?
We are both physicians and have two toddlers. Currently we are focusing on just paying off our student loans and ensuring our retirement. We will work to insure their success by giving them access to valuable activities/classes/music lessons/schools with good level of education. They will then use this as a launchpad to make it. Rather than saying “hey I saved all this money for you”, I think that sends the wrong message. I would say people on this board are successful because they had the drive to figure things out on their own financially, usually because there was some financial need. Otherwise you do not know what it is like to reduce costs/save/plan for the future.
I’m not sure that I can re-create for my kids situations where they will see what is value of say $5. Situations where you decide to go without one necessity because you have to buy a more needed necessity.
There are online, prefabricated-trust companies that charge 50 basis points/year. Taxes on trusts are pretty onerous, but a $100k trust could be funded in 4 years (24×4) without diminishing your estate tax exemption. If funded with Vanguard Total Stock Market Index Fund Admiral this would pay out about 2% of qualified dividends per year; first $1000 no taxes, second $1000 taxed at child’s tax rate. The “drag” on the portfolio would probably be 0.6% to 1.5% (taxes and expenses) depending on account size. I recognize this costs a lot more than a UTMA account, but has some other selling points also. I haven’t done this, but I have thought about it (maybe more than I should). Obviously, not as good as a Roth, but if your child doesn’t have earned income, and the many UTMA regret stories give you pause… Also, it doesn’t look so bad compared to variable annuity expenses. Thoughts? I am definitely not trying to talk anyone into this.
A reasonable option if control is important (which you don’t get with an UGMA or VA or Roth), a Roth is unavailable, you’re don’t want to invest in a tax-inefficient asset like REITs (where a VA would be better) and the account won’t be too large.
If you had to choose, would the better choice be to fund a Roth or an education account (529, Coverdell)?
Also, the inevitable question, WCI what are you doing for your kids?
It depends on the goal. If your goal is to pay for their college, use a 529. If your goal is to pay for their retirement, use a Roth. You can use either to teach them about the importance of investing and saving.
My kid’s don’t have earned income, but when they do I like the idea of having them spend most of their money while I put an equal amount into a Roth as a daddy match. For now, they each have a 529 and they will also have an UGMA to help pay for expenses in their 20s (car, marriage, home downpayment, mission, summer in Europe etc).
I was eating dinner with a bunch of docs the other night, all of whom spend $60K a year on tuition for their kids. I won’t be doing that.
I love the idea of starting a Roth IRA for my 15yo daughter. I am employed physician( don’t have my own practice/ LLC or any business). If I have my daughter do babysitting( she took a babysitting course and is CPR certified) / chores .. will that suffice as income accdg to IRS standards? In terms of proof of income- how do I document that (payment for chores or babysitting) ? What legal documents should I have ready for IRS just in case of audit. Thanks in advance!