William Reichenstein is Powers Professor at Baylor University and head of research at socialsecuritysolutions.com.
Parents or grandparents of recent college graduates who want to help children get on the right financial footing may actually want to focus on their retirement.
Recent graduates tend to be in low tax brackets in their early working years–when it pays for them to save as much as they can in a Roth IRA or Roth 401(k). And a matching contribution from a parent or grandparent could make a huge difference. In some instances, the payoff could be greater than starting out with a tax-advantaged IRA or 401(k).
Take the example of Bob, who graduated from college this year at age 22. Bob may retire in 43 years, and will likely need to save for a 30-year retirement. For every three years of work, he must save for 2+ years of retirement.
Bob will begin work in sales in September and expects to earn an annual starting salary of $57,000, which translates to $19,000 for the remaining four months of 2017. As his sales base grows, his income is expected to grow in future years. His employer offers a 401(k) and a Roth 401(k).
Bob will be in the 10% tax bracket this year and is willing to reduce this year’s spending by $1,800. He could save $2,000 of pretax funds in a 401(k). This $2,000 contribution would reduce his income by $2,000, which would reduce his taxes by $200. Alternatively, he could save $1,800 of after-tax funds in a Roth 401(k). These contributions are equivalent because each would reduce this year’s spending by $1,800.
In either case, we’ll assume that Bob invests the money in the same mutual fund that averages a 7.21% return for the next, say, 53 years at which time Bob will be 75. Its value increases 40-fold and Bob anticipates being in the 25% tax bracket when he retires
Tax law allows Bob to contribute up to $18,000 to a Roth 401(k) for 2017. Obviously, his limited income would prevent him from making such a contribution level. However, suppose Bob has parents or grandparents who are willing to give him $10,200 as a gift to add to the $1,800 he is able to contribute to his Roth 401(k). In this case, Bob could contribute a total of $12,000 to his Roth 401(k) for the year. If this $12,000 grows at 7.21% for 53 years, it would be worth $480,000 after taxes when Bob is 75. And this doesn’t take into account any additional contributions Bob will make over the course of his career.
If Bob’s employer does not offer a retirement plan then, perhaps with the financial assistance of his parents, he could contribute $5,500 to a Roth IRA–which could be worth $220,000 at age 75.
Sure, Bob’s parents or grandparents could buy him a used car costing $10,200 instead. But I believe a lot of young graduates would prefer the jump-start on a financially secure retirement.
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