Sir Isaac Newton's First Law of Motion states that an object at rest will remain at rest until an agent of change forces it to move. Once set in motion, the object will maintain the same speed and direction until something forces change again.
Newton's Law applies to human motivation as well as objects. William James, the father of American psychology, illustrated this relationship with following story. James was lying in bed on a cold winter morning. The bed was warm - the room, freezing. As he lay on his back, his breath filled the air with crystalline plumes of vapor. He was comfortable and content under layers of blankets. Getting out of bed meant pain and discomfort. He shuddered at the thought of walking barefoot across the room to rekindle the fire. Minutes ticked away as James' mind sifted reason after reason not to change its peaceful status. Suddenly, a greater realization brought him to his feet: The fire wasn't going to start itself. No fire meant no breakfast. And besides, he had work to do.
We can all relate to James' experience, and it helps explain why it is so hard to lose weight or stop smoking. Like objects in motion, we tend to maintain our speed and direction - our habits of thought and action - until a greater force, such as doctors' orders, compels us to change.
Newton's Law also sheds light on an irksome financial mystery - why so many people avoid saving for retirement until the shadow of middle age - and sheer panic - finally spur them to action. The consequence: We must save more to retire with less money than if we had started saving earlier.
So, what does this have to do with taxes? If you're a parent, the tax code provides a solution that will remove the Newtonian-savings dilemma from your children's future. This solution is a Roth IRA.
A Roth IRA can be established for anyone, including children, who have "earned income" (from a job). Under current rules, qualifying individuals can place up to $5,000 into a Roth each year. Although no tax deduction is allowed for Roth contributions (which wouldn't benefit most kids anyway), interest compounds tax free and, if not withdrawn until age 59 1/2, can be removed completely tax free. What impact could this have on your child's future? Let's consider two common scenarios.
Jack is a typical 35-year-old who suddenly realizes he is getting older. Jack scrimps and struggles to put $417 into a Roth IRA each and every month ($5,000 per year) for the next 30 years. In all, Jack places more than $150,000 in his account. If his Roth earns an average of 8 percent per year, a fairly realistic assumption, Jack will have approximately $620,000 to retire on when he reaches age 65.
Jill, on the other hand, is a typical American in her early 20s - thoughts of retirement far, far away. When Jill was very little, her parents decided to set aside $50 each month for her future. Then, when Jill started working part-time as a teenager, they established a Roth IRA in her name and, as she earned income, began moving funds from savings to her Roth. By the time Jill was 20 years old, her Roth had a balance of $25,000, an amount that will continue to grow, tax free, until Jill is ready to retire. If Jill's Roth earns the same average annual return as Jack's, 8 percent, the $25,000 seed planted by her parents will be worth more than $900,000 on her 65th birthday.
So, let's recap.
Jack starts saving when he is 35 years old. He saves $5,000 each year for 30 years, more than $150,000 in total, and accumulates $620,000 for retirement.
Jill starts out with $25,000, saves nothing, and ends up with $900,000, 45 percent more money than Jack. For the price of a car or a semester at many universities, Jill's parents have used the tax code to give their child a gift of priceless value - a financially secure and tax-free retirement.
- Brett Hersh is the owner of HBS Tax. He is an IRS Enrolled Agent licensed by the U.S. Treasury to prepare all income tax returns and represent taxpayers before the IRS for audits, collections and appeals. He is also Dave Ramsey's regional representative for tax and accounting. He can be reached at 304-267-2594, at email@example.com or through www.hbsbusiness.com