At Altavista we enjoy spending time helping clients and their families in a variety of ways. A few months ago, we were meeting with clients who had young adult children in their 20s. They were starting their careers in the family business and earning income from their jobs.
Like most young adults in this age bracket, we were helping them learn the important financial skills of budgeting, managing student loans, figuring out taxes and trying to save for retirement. All part of the financial learning curve we often see for young adults.
In our conversation, the parents were debating how to best transfer money to their young adult children. They wanted to do so in a way that would promote responsibility and stewardship with their finances. We were also thinking about a way AWM would continue to work with their young adult children on the principles of financial planning. We were all focused on how best to work with the “Next Gen” and planning for their financial future.
After discussing a couple of ideas, we decided a better approach than making an outright gift or writing a check would be for the parent to gift the money to young adult’s ROTH IRA. In a way “matching” compensation from their work in the family business to help fund their ROTH. This decision had multiple benefits. It was a nice complement to supporting their children while allowing them to learn about investing for the future and the lessons of financial responsibility.
How to give a gift that last for decades-
The IRS permits gifts to a ROTH IRA under certain conditions. For this strategy to work, a few technical items to review–
- The donee (aka young adult) must have earned income during the year.
- Income can be reported on a W-2 or 1099. Income is also defined as earned income from a summer job or part time job which makes this work for young kids too! The key here is the income must be earned. Investment interest and dividends are not considered earned income for a ROTH contribution.
- For 2021, contribution amounts to a ROTH are the lessor of earned income or $6,000.
- The amount contributed to a ROTH cannot exceed compensation earned by the account holder. For example, a young person earns $4,000 in compensation during the year, the max that can be gifted to their ROTH account is $4,000.
- For contribution calculations, parent and child can not contribute more than $6,000 combined into the ROTH IRA per year. Again, this is assuming there has been enough earned income by the child during the year.
- There is a limit on how much a young person can earn to put money away in a ROTH IRA. For 2021 an individual filing separately needs to have less than $125k in Modified Adjusted Gross Income (MAGI) to take advantage of the full contribution. Between $125k and $140k in MAGI, the amount a single filer can put into a ROTH begins to phase out. If a single filer makes more than $140k in AGI, a Roth contribution is phased out.
- For high earning young couples who are married filing jointly, one can contribute to a ROTH IRA with less than $198k in MAGI. If MAGI is greater than $198k but less than $208K, the amount permitted to contribute to a ROTH begins to phase out. If MAGI is above $208k for married filing jointly a ROTH contribution is phased out.
- Please see the attached IRS link for further information on contribution limits. 2021 ROTH Contribution Limits. We also recommend consulting with your CPA before gifting to a ROTH IRA.
Gifting to a ROTH IRA in this scenario can provide multiple benefits. A few of the benefits are listed below-
- With a long–term time horizon, assets in the ROTH have the opportunity grow and compound interest in a tax free environment.
- With current tax laws, withdrawals from a ROTH IRA after age 59 ½ can be done so without penalty and tax free. Further, there are no Required Minimum Distributions (RMDs) required from ROTH IRAs. Potentially allowing more time for assets to grow.
- Creates an opportunity for a young person to learn how money can be responsibly invested and get in the habit of saving early and often for their future. A great way to help younger adults and older children develop a financial acumen that will last a lifetime.
- Allows the “Next Gen” to work with the family’s AWM advisor on their goals and dreams.
- Others can gift to a ROTH IRA beside parents. This includes, and not limited to, Grandparents, Aunts, Uncles, God Parents, and family friends.
- An adult child with solid retirement savings allows the parents to enjoy their own savings in retirement.
Please reach out to your Altavista advisor if this strategy would benefit younger adults, children, or grandchildren in your life. We are happy to discuss how this approach can help teach the younger generation about saving, investing and financial responsibility. As we turn the page on winter and look forward to springtime, it is never too early to plant the financial seeds in a young person’s ROTH IRA.