Focus on Personal Finance
Give Youngsters the Gift of Thrift
Your kids or grandkids may be earning, but are they saving?

If you're like most hard-working ophthalmologists, you want your teen-age children or grandchildren to learn how to handle their money wisely. There's no such thing as starting too early in developing habits of thrift.

Do the youngsters you love understand the time value of money or compounding rate of return? Stated more simply, are they spending the money they earned from summer jobs on new clothes and sound equipment? Or have they thought about investing some of their hard-earned cash? Maybe it's time to have a heart-to-heart talk about saving for the future. Better yet, you can show them what this means "up close and personal" with their earned income.

Does this scenario sound familiar? Your teen earns some cash from a summer job or from part-time employment throughout the year, but she spends it all. Here's a perfect opportunity to begin some creative financial planning for saving some of her earned income.

GETTING A HEADSTART ON SAVING

Make the tax laws work in your favor. Your teen can contribute to a Roth Individual Retirement Account an amount up to the contribution limit ($2,000 in 2001) or her total earned income, whichever is less. Remember, earned income means wages reported on a Form W-2 as well as income earned as an "independent contractor" that's reported on a Form 1099.

The tax law enacted this year increases the Roth IRA contribution limit to $3,000 in 2002-2004, $4,000 in 2005-2007, and $5,000 in 2008. Contributions to a Roth IRA aren't deductible from taxable income, but the teen probably has a small tax liability anyway. If she contributes the maximum amount at the end of each year from 2001 until 2010, she'll have socked away $38,000 to start a retirement fund.

At the end of this 10-year period, the account balance would be $52,000 at an 8% annual rate of return. If she makes no other contributions, and the $52,000 account balance stays invested for another 40 years, she'll have more than $1.1 million (based on the 8% annual return) to use during her retirement years. The earnings on the Roth IRA investment are never taxed. (Remember, you already paid tax on the contribution amount.) When qualified withdrawals are made, no tax is due.

If thinking about reaching age 66 doesn't compute with your teen, perhaps you can interest her in another scenario.

A PATH TO HOME OWNERSHIP

One type of qualified distribution has nothing to do with retirement, but can be a huge help for a young adult who's buying a first home.

If the Roth IRA has existed for at least 5 years, and the withdrawal is used for the purchase of a first home, a distribution of up to $10,000 of earnings is completely tax-free. Contributions can also be withdrawn with no tax liability and can be used for any purpose, including the home purchase.

With contribution limits for IRAs increased by the Economic Growth and Tax Relief Reconciliation Act of 2001, a youngster can accumulate a substantial nest egg in which the investment growth is never taxed. The key is to interest your teen in saving for her future retirement or first home purchase.

YOU'RE ALLOWED TO HELP OUT

If the summer job cash has already been spent, you can gift your teen the $2,000 for her Roth IRA contribution. The only requirements are that she reports earned income of at least that amount on her return and her adjusted gross income isn't greater than $95,000.

Teaching your child or grandchild about the value of delaying immediate gratification for financial security is time well spent. The actual experience is better than delivering 100 lectures.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., and Anita S. Frank, CPA, are president and tax manager respectively, of The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group provides personalized fee-only financial planning, investment management and business consulting services.