Without much prompting, Mark Hyma enthusiastically shares one of his mainstay rules for clients’ financial planning: “Everyone who can fund a Roth IRA, should fund a Roth,”
He is the president of Professional Financial Services of San Diego, which uses HD Vest Financial Services as its broker-dealer. Based in Irving, Texas, HD Vest advisors focus on both tax and financial planning.
By “everyone” Hyma’s rule covers children who have earned income that is then reported by an employer on a W-2 tax form. Admittedly, those children, earning a paycheck often for the first time in their lives and getting the thrill of spending their own money, will likely not share the motivation of their forward-looking parents about a maximum Roth individual retirement account contribution.
So such a scenario might only happen if the parents pony up the money. But the strategy creates multi-generational tax savings, as long as the parents have enough income to first contribute to their own retirement accounts.
Why? The children are typically not earning enough to owe any taxes, therefore, they won’t pay taxes on their W-2 income.
If they keep the money in the Roth IRA until the government allows qualified distributions when they reach 59 1/2, they will never pay taxes on the principal and all the capital gains they earn all those years.
The strategy takes some planning, and Hyma concedes that even if the child earns a maximum Roth IRA contribution of $5,000, it “may be pretty hard for the average American family” to contribute that much to the child’s account.
He also says that parents should forgo providing the Roth IRA funding until after the children receive their W-2s as the government charges significant penalties for any contributions in excess of the income earned in each tax year.
For advisors, Hyma says the concept isn’t a hard sell.
“It’s relatively simple, and once you show parents the wisdom of this, they get it pretty quick,” he says.
“It is important for parents to teach children, even young ones, the power of saving,” says Chad Smith, a wealth management strategist, also at HD Vest.
An often overlooked additional benefit of contributions to children’s Roths IRAs is that the accounts serve as a possible source for tax-free college funds. Withdrawals from Roth IRAs are tax-exempt if the funds are used for qualified educational expenses, including tuition, books, and room and board.
Notably, only the contribution portion -- not any capital gains -- may be withdrawn tax-free for qualified educational expenses, Smith says.
Miriam Rozen is a staff writer for Texas Lawyer who writes about financial advisors.
This story is part of a 30-day series on tax planning strategies.