Around the holidays I am reminded of an idea I presented to the editor at the Pittsburgh Post-Gazette, which I called “a gift better than socks.” I also presented it on radio, and it was well-received by both audiences. It revolves around the conundrum grandparents find themselves in when trying to find a gift for their grandkids—one that wouldn’t be wasted or tossed to a corner in their closet. Many grandparents want to be able to give something meaningful that will have more than a glancing impact on their lives. So, I came up with an idea from an investing perspective that would be much better than just buying another pair of socks or meaningless toys.
Of course, the idea is not limited to grandparents. It’s for parents, aunts, uncles, or anyone who has a young person in their lives who want to do something special for them. They could still buy socks or toys, but this is a gift that would provide more lasting value.
The Gift that Keeps on Giving: How it Works
Consider the following scenario: Johnny, age 10, is a grandchild who likes to spend time with his grandparents and help them out by doing chores around their house. He might help with mowing the lawn, cleaning up the leaves, doing the dishes, or cleaning the kitchen after each meal. So, you can think of those chores as services provided (even though it’s just what a loving grandchild would do). Therein lies the opportunity for what could be an incredibly powerful gift with significant tax preferences.
For “services rendered,” Johnny’s grandparents could open an account on his behalf. In most states, an account for minors can be opened under “uniform gift to minors” rules at a bank, mutual fund company, or brokerage firm. The child is the account owner, and the grandparent, parent, or uncle would be the custodian. That’s pretty standard practice for establishing a savings account with gifted monies for minors under the age of 18 or 21, depending on your state.
But what makes this a truly remarkable idea is that the account is set up as a Roth IRA, which wouldn’t be possible normally because Johnny would need to have earnings to be able to contribute to it. That’s where Johnny’s earnings from his grandparents for services rendered come in. And that’s where the three tiers of tax benefits begin.
Tax Benefit #1: No taxes paid on grandchild’s earnings
As Johnny’s “employer,” the grandparents may pay him up to $599 each year without having to file a Form 1099. In other words, the compensation they pay Johnny for his chores doesn’t have to be reported to the IRS if it’s under $600. That means Johnny has $599 of earnings that can be contributed to his Roth IRA. As for the grandparents, they don’t even have to maintain a record of the payment because the IRS doesn’t care. The first of several tax benefits is that Johnny can receive the compensation without having to pay taxes on it.
Tax Benefit #2: Tax-free accumulation of funds
But it gets better. Because the account is set up as a Roth IRA, all earnings inside the account accumulate tax-free. That means the earnings will be left alone to compound more quickly. That second tax benefit will have the most significant impact on Johnny’s future. Assuming a reasonable average return of 7% in an index fund, if left to grow for 50 years, a single deposit of $599 would grow to just under $18,000. If you continued annual payments of $599 for another seven or eight years, Johnny would be looking at a six-figure accumulation! That’s a real legacy.
Tax Benefit #3: Tax-free withdrawals
Finally, when Johnny turns 59 ½, long after his toys and socks have turned to dust, he can have unfettered access to those funds, free of taxes, which is the defining benefit of a Roth IRA.
I’ll never forget my grandparents, but I can’t say the same for most of the presents they gave me for Christmas or on my birthday. Through the magic of compounding (with an assist from the IRS), this is a wonderful way for your grandchildren (or kids, or nieces and nephews) to remember them and the impact they had on their lives.