A“tweet” from GETTING YOUR FINANCIAL DUCKS IN A ROW author Jim Blankenship, anEnrolled Agent, led me to his post “How To Turn $5,000 A Year Into a $33 Million Legacy” from August of 2009.
Forgetabout the $33 Million. Let us look atthe beginning of the example he uses (the highlights are mine) -
“Once upon a time, there was this guy namedJoe. He was 20 years old, workingpart-time making decent money, finishing up college, just generally livinglarge (by a 20-year-old’s definition). On the advice of his father (yes, some 20-year-olds listen to theirfathers!), he opened up a Roth IRA, funding it with $5,000. The account was invested in a fixed 5% yieldinstrument of some sort (not important what the investment is, just assume a 5%annual yield).
Using the Roth IRA isadvantageous to Joe because his tax rate is very low at this stage of his life– presumably tax rates will be increasing for him in the future. Any growth on this account is tax-deferredand most likely tax-free, as long as any future distributions are for qualifiedpurposes.
Each year thereafter,Joe contributes an additional $5,000 to the Roth account. After he completes college, he starts workingat an entry-level job. Not long after,he marries his high school sweetheart Jane, and they settle into theirlife. As life goes, they soon havechildren in their household, and even though money is tight, Joe continues tocontribute the $5,000 each year into his Roth IRA. This goes on for a while.
And then… 20 yearspass
At age 40, Joelaunches his own business. During thistime in his life, tax deductibility becomes more important to him since he’smaking a lot more money and is in a higher tax bracket – and so he stopscontributing to the Roth IRA.
All this time, hisinvestments in the Roth account have been steadily growing at that fixed 5%rate – and the balance is now up to $165,329– on 20 years’ worth of $5,000 investments, for a total of $100,000 contributed. Pretty nice, right?
Joe just sets the Rothaccount aside at this point, forgetting about it altogether for quite a while(other than those pesky quarterly statements). Not much happens here for a long, long time, other than compoundinginterest, time passing, and continued tax deferral.
… and another 50 yearspass
Joe is now age90. His business has flourished throughthe years, and now his children are reaping the benefits of having workedthere, and now retiring. Hisgrandchildren have taken over the business, and he and Jane are enjoying theirgreat-grandchildren. A couple of yearslater, little Jolene is born, and this great-granddaughter quickly becomes theapple of Joe’s eye.
It is along this timethat Joe remembers that long lost Roth IRA account. To this point it has grown to over $2 million – from that original series of $5,000contributions that amounted to a total of $100,000.”
Thisis a great example of the effects of tax-free compounding. Joe has built up $2 Million that he can passalong to his beneficiaries income tax free.
Thinkwhat the account would be worth if he had continued to make the maximum annualcontribution (including catch-up amounts when he turned 50) from age 40 to age65, then retired and began to take tax-free distributions from theaccount. He would have a humungousretirement nest-egg for him and Jane to enjoy in their “golden years”, andstill have a substantial tax-free legacy to leave to the children andgrand-children.
Parentstake note – when your children begin to have part-time after-school and summerjobs - if you can afford to do so - open a ROTH account for them and depositthe maximum allowed. Continue throughtheir first few years of full-time employment after graduation until they canbegin to make the maximum payments themselves.
Ofcourse the story of Joe assumes that the idiots in Congress do not FU the ROTHIRA in the future.
TTFN
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