Do you want to make a difference in your child's life -- one that will grow ever more significant as time goes by?
Here's one way: Give the gift of a retirement starter account. Not only could you make a huge positive impact on their financial future, but you could also teach them an invaluable lesson about the importance of savings and investing.
With that in mind, let's look at some simple ways that you can spend $1,000 (or less) to create a beginning retirement fund that stands to grow many times over before your child finishes his or her working career.
Starter retirement options
The most complicated part of giving a starter account as a gift is choosing the investment vehicle itself. Here are two options that retirement gift-givers can consider.
Often associated with college savings, these can work as a starter retirement instrument as well. By establishing a brokerage account under the Uniform Gift to Minors Act or the Uniform Transfer to Minors Act -- the version that applies will depend upon which state the recipient calls home -- a parent, grandparent, or guardian can create a retirement starter account with negligible impact on taxes for all.
The IRS will not tax the giver for a gift as small as the one we're considering, because gift taxes typically kick in at $14,000, and income tax for the recipient doesn't apply to the first $1,000 in the account. The next $1,000 is taxed at the minor's rate -- usually 15% until age 19, or age 23 if he or she is a student. Anything beyond $2,000 is taxed at the parents' rate until the recipient reaches age of majority, which ranges from 18 to 25 years old depending on the state. As the giver, you appoint a guardian to oversee the account (it can be you). Control transfers to the recipient at age of majority.
Want a specific retirement-only vehicle that can be established at a young age? A Roth individual retirement account allows a gifted investment to grow tax-free until the account holder turns 59-1/2. The key to this vehicle is that your young person needs to have earned income during the year that contributions are made -- including your initial contribution that started the account. The recipient's income determines the contribution cap, especially at lower levels. In our modest-gift model, you just need to know that the contribution limit matches annual earnings of less than $5,500 dollar for dollar. That is, if your nephew is the recipient and he earned $1,000 mowing lawns over the summer, then the contribution limit for starting the account that year is also $1,000. When he reaches age 59-1/2, he can make withdrawals from the account without incurring penalties or taxes. The early withdrawal penalty of the Roth IRA serves to deter the account holder from taking distributions before retirement, whereas an UGMA/UTMA account comes without that incentive.
How much does your gift stand to grow?
Think of it this way: If you create one of the preceding accounts in the amount of $1,000 for your young person when they're 17, and the portfolio returns 7% for 50 years (we're figuring a 25% tax rate on the individual, though our UGMA/UTMA account-holder might get a few years' reprieve), it would still work out to nearly $30,000 at the end.
And that's if you don't contribute another dime -- which is probably unlikely, especially if your recipient sees how the account can grow over time. Even at the most conservative end of the contributions spectrum, however -- say your receiver put in just $500 per year -- he or she would have nearly $250,000 waiting at age 67.
In both cases, we figured results using one of the numerous online retirement-returns calculators. Using the same kind of tool, you can estimate your own account endpoints based on different time frames and contributions.
And as the young person's account grows, you can show them statements on a monthly or quarterly basis, further enhancing your gift by illustrating the engine that is compound interest, and perhaps also introducing the concepts of company research and how stocks perform over time.
The dual gift of a retirement account and some simple lessons on investing can have a profound impact on a young person's financial future.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
More from The Motley Fool
GE Heads Toward a Low, Tiffany's Hits a High
And in between, we’ve got news from Nestle and Papa John’s.
Why BP Prudhoe Bay Royalty Trust, Albemarle, and Adtran Slumped Today
One of these stocks dropped after making a lucrative payout to shareholders. Find out which one.
3 Things That Can Go Wrong for Netflix on Monday
Momentum is in Netflix's corner, but valuation and growth concerns, and even the upcoming Winter Olympics, can shake things up for the streaming-video pioneer.