“The sooner you start saving, the sooner you can stop, kick back and watch your investment returns build on themselves, thanks to the power of compounding.”
That’s what you should tell the young adult in your life when you give him a Roth IRA contribution for graduation. There’s a decent chance he won’t listen, but he’ll be oh, so grateful a decade or two from now.
The power of the Roth
Why does a Roth IRA make a great graduation gift? It’s because young adults have the powers of time and compound interest on their side. And don’t forget: Roth IRA investment earnings grow tax-free.
“If they can get money put away before they’re 30, even if they don’t contribute another dime, their portfolio will grow,” says Morris Armstrong, an enrolled agent and registered investment advisor at Armstrong Financial Strategies in Cheshire, Connecticut, on the topic of people who start saving early.
The graduate must have income from work this year — that can mean from a job or a freelance gig, such as babysitting. The maximum annual contribution is $5,500 or her total earned income, whichever amount is less.
Here’s an illustration of how a single Roth contribution can grow over time:
Not just a handout
Giving a Roth contribution isn’t only about giving away your money.
It can get a college graduate “thinking early about saving and investing,” says David Hays, president of Comprehensive Financial Consultants in Bloomington, Indiana.
One way to get buy-in from a young adult? Offer a match, where you put in $1,000 for every $1,000 they put in (up to the Roth IRA limits, of course).
One way to get buy-in from a young adult? Offer a match.
Also, sit down with your college grad to help open the account. Rather than an electronic funds transfer, consider writing a check — brokers such as Charles Schwab and Vanguard offer mobile deposit for IRA accounts — to make the event more significant, says Sabrina Lowell, a certified financial planner, advisor and chief operating officer at Mosaic Financial Partners in San Francisco.
“Give them a check to deposit so that it’s very clear that the account is going to be opened and funded,” Lowell says.
Not quite a ‘gift’
There’s a hitch. “Technically, there’s not a way to gift an IRA,” Hays says. The college grad has to open the account. “Then, you give them the money and they contribute to it.”
Of course, “contributing” to a Roth IRA generally means “investing.” Don’t worry too much about the complex ins and outs at this point, Lowell says.
For people just starting out, a low-cost target-date mutual fund, which offers a diversified portfolio, can work — some charge fees as low 0.2% or less. Another idea is a robo-advisor: a company that handles investment management for you for a low fee (often about 0.25%). See if a robo-advisor is right for you.
There might be situations where giving money to a college grad isn’t the best idea.
“Your graduate will sign the paperwork and the account will be your child’s to do with what they wish,” says Brad Klontz, a certified financial planner and associate professor of practice in financial psychology at Creighton University in Omaha, Nebraska. “If they have a history of poor financial decisions, don’t be surprised if they cash it out to fund their current financial needs or whims.”
He’s got a point. It’s really easy to withdraw Roth IRA contributions. For some, that might mean they derail their retirement savings. Here are the rules on Roth IRA withdrawals.
You don’t want to set the stage “for disappointment and resentment,” Klontz says, so if that’s a risk, consider keeping your money under your control until your college grad is heading toward greater financial prudence.
Rules to watch for
- The college grad must have money earned from work this year; that could be a freelance gig or a part-time job.
- The maximum amount the college grad — that is, whoever owns the account — can contribute in a year is the lesser of these two options: $5,500 ($6,500 if 50 or older) or her earned income.
- There are income limits on Roth IRAs. For single people, the maximum contribution amount starts to phase out at modified adjusted gross income of $120,000. We detail the Roth rules here. If your college graduate “is coming into a field where they might be making a lot of money, they could potentially hit the earnings limitations and not qualify for a Roth,” Hays says.
- The grad has to set up her own Roth account. You can write a check directly to the custodian where the account is located or to the student.