Parents often share the common financial goals of wanting to own a home, educate their children, and to retire comfortably. When it comes to their children, parents want the best.
Traditionally, parents want to help pay for their children’s college education and send them out into the working world armed with a degree. Today, with the ever-increasing cost of college, some parents are re-evaluating where to direct their hard-earned dollars to maximize the benefits for their children.
For an example, one couple was intent on investing a lump sum of money toward their daughter’s future; however, they weren’t sure that paying for her college tuition was going to be the best way to do that. They discussed with a financial advisor some common financial investments parents tend to make in their children including a college education, paying for a wedding, helping with the down payment for a first house, and even retirement.
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They had already planned for their own retirement and had just received $100,000 via inheritance. After watching others struggle in retirement, providing a dignified retirement for their daughter was of particular interest to them.
These parents understood the powerful impact that time and compound returns have had on their own retirement portfolio. It sparked an interesting thought: “Rather than put the $100,000 toward paying her college tuition, what kind of impact would over 40 years of potential compound returns have on our daughter’s retirement plan? Especially so, if we were able to help her aggressively save for retirement in her early 20s and have the money grow tax free?”
While their daughter is in college, the $100,000 could be invested in a taxable account with an allocation designed for growth, based on a retirement date over 40 years away from when their daughter would start working.
Upon graduation, when their daughter joins the workforce, they could begin using these funds to supplement her income. They would make an agreement that their daughter would make the maximum annual employee contribution ($18,000 in 2016) each year to an after-tax Roth 401(k). Their daughter would contribute to her Roth 401(k) via payroll deductions and then her parents would reimburse her dollar-for-dollar. This way she may still live on her full paycheck.
The logic for the Roth 401(k) being that their daughter’s income would likely be lower early in her career, making her after-tax contributions that grow tax free for retirement, especially beneficial.
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By repeating this process each calendar year, until the funds are fully invested into her Roth 401(k) and assuming a 7 percent hypothetical annual rate of return, the balance may grow tax-free to $1.5 million over the next 40-plus years. A potential $1.5 million-plus retirement nest egg without their daughter ever making another contribution toward her retirement illustrates the benefit of starting early and the powerful effects of time and compound returns.
The opportunity cost, of course, is that their daughter would need to take out student loans to pay for college. While many students are burdened with college debt, her parents felt that by taking an active role in educating their daughter about her finances and teaching her how to pay down her student debt from her own income would be a valuable life lesson. Learning to live within your means while paying down debt is a reality for many of today’s college graduates.
By making a concerted effort to improve their daughter’s financial literacy, and by including her in regular financial planning meetings, her parents hope that the strategy to save for her retirement will be more likely to have a successful outcome.
Their daughter would need to be on board with the plan over the long run, considering the possibility that a 20-something year old might be tempted to liquidate or raid a substantial retirement account.
They are also evaluating additional options that may include funding a Roth IRA for their daughter just as soon as she has earned income from a part-time or a summer job.
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Ultimately, by teaching their daughter about the benefits of planning to save and invest for the long term, her parents offer their daughter the gift of her first steps on the path to financial freedom in retirement.
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