Encouraging Younger Family Members to Save

Clients who take advantage of the $14,000 gift tax annual exclusion [Code §2503(b)] to make tax-free gifts to children and grandchildren (increasing to $15,000 in 2018) may want to encourage the use of some of these funds to establish IRAs.  Consider a grandfather who makes annual gifts of $10,000 each to his three teenage grandchildren, all of whom have part-time and summer employment.  If $5,000 is contributed to a grandchild’s IRA every year for five years — starting when the grandchild is age 16 — the balance in the account would grow to $29,875 (assuming 6% interest) by the end of the fifth year.  By the time the grandchild is ready to retire at age 67, the account will have grown to more than $400,000, even if no further contributions are made.  But if the grandchild continues making $5,000 contributions annually until retirement, the account could grow to more than $1.5 million.  A note of caution: In our example, the grandchild must have at least $5,000 of earned income in any year during which a $5,000 contribution is made (Code §408).

A Roth IRA is another alternative, particularly since the grandchild is unlikely to need the deduction offered by a traditional IRA.  Generally, a Roth IRA must be held for five years before withdrawals are tax free, otherwise the earnings on the contributions would be subject to tax. On exception would allow the grandchild to withdraw up to $10,000 tax-free for the purchase of a first home.


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