Henssler Financial believes that one of the easiest ways for parents to give their child financial freedom is to fund an IRA. By establishing an IRA for your child while he or she is young, you can give your child a head start on retirement, as well as begin cultivating healthy savings habits at an early age. For more information on the requirements for establishing an IRA for your child, read “Funding an IRA for Children.”
In this article, we will address the decisions you must make when funding your child’s IRA.
First, you should decide either to fund a traditional IRA (whether tax deductible or not) or a nondeductible Roth IRA. We typically recommend against making a nondeductible traditional IRA contribution. We feel that the limited amount of tax savings received by a deductible traditional IRA contribution is more than outweighed by the long-term tax savings of the Roth IRA. By definition, if your child can contribute to a nondeductible traditional IRA, they should be able to contribute to a Roth IRA up to certain Adjusted Gross Income limits. These income limits should not be an issue for a child under the age of 21.
With a traditional IRA, your child will be required to begin making mandatory withdrawals at age 70½, under the current law. Those withdrawals are taxed as ordinary income at the time of withdrawal. However, there are no mandatory withdrawal rules for a Roth IRA. Once your child reaches the age of 59½, they can begin pulling money from their Roth IRA, without paying taxes. Furthermore, you are allowed to withdraw your principal contributions from a Roth IRA at any time, without paying a penalty or income tax. This cannot be done from a traditional IRA. Our position is that your child should have greater tax savings in the long term by funding a Roth IRA rather than a deductible traditional IRA.
Your next decisions will be how to invest the contributions. Our recommendation is to invest this money for long-term growth. This means 100% equity investments rather than buying fixed income securities. We work with a simple investment philosophy we refer to as the Ten Year Rule. This rule basically states that any money you need in the next 10 years should be invested in fixed income securities NOT equity investments. Any money you do not need in the next 10 years should be invested in high-quality, individual common stocks or mutual funds that invest in high-quality, individual common stocks.
These contributions should be viewed as a way to help fund your child’s retirement; therefore, your child should not need this money for at least 20 years. With that time horizon, in our opinion, you should invest in the stock market.
When an investment vehicle has been decided, keep a few things in mind. You are investing for the long run. It should not matter to you what happens in the stock market from one year to the next. The only time you should care about what the stock market is doing is the year you plan to sell. Think about it: If you do not plan to sell and you are invested in quality companies, what does it matter what the market is doing? It only matters when you plan to sell.
Since you are looking at a minimum 20-year investment time horizon before your children should need this money, do not worry about the short term. If you have invested in a broadly diversified equity mutual fund that invests in high-quality companies, over the long run you may be pleasantly surprised. The market’s daily fluctuations are normal. Do not let these fluctuations scare you into doing something unwise.
With time on your side, invest aggressively. This means invest in common stocks not in fixed-income securities. However, this does not mean invest in any Dot-Com company or the next highflier. Invest in mutual funds that invest in high-quality, common stocks. Remember, a company’s stock can always come back from a market dip, but a company generally does not recover from bankruptcy.
Considering that you have at least 20 years or more to be invested, common stocks are the only investment we suggest for that period of time. According to Ibbotson Associates 2009 Yearbook, which tracks returns back to 1925, there has been only one 20-year period of time when fixed-income securities outperformed common stocks. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].