The magic of setting up a Roth for children

Q: My wife and I have two daughters, 12 and 17, and we have a very good income, have pensions, a 401(k), a couple of large annuities and also college funds for our girls. We would like to start a fund for our girls that they could use in the future for a down payment on a house or for any other purpose. What would be an appropriate long-term investment for them?

— L. H.

A: Your daughters are very fortunate. Even if you stash away a small amount of savings for them now, that stash has the potential of turning into a delightful sum because the girls are so young. Let's assume you save $1,000 now for the 12-year old and then save another $1,000 for each of the next five years. Then, you stop saving additional money for her because you are going to be paying for college.

If you invest the money in an index mutual fund that mimics the stock market (the Standard & Poor's 500), and it grows 9.5 percent a year on average, your 12-year-old daughter could have more than $15,000 for a house payment when she's 25.

But if she doesn't need the money for a down payment and leaves it invested until she retires, she could have about $500,000 for retirement. That's right. After investing just $1,000 a year for six years, or a total of $6,000, she ends up with about $500,000 if she earns about 9.5 percent a year on average on her fund. That might seem like a silly assumption after the horrible last few years for the stock market, but 9.8 percent is what the stock market has gained annually on average during the past 86 years.

Try different assumptions on the compounding calculator at Moneychimp (moneychimp.com).

Still, to get the most out of savings, I suggest opening a Roth IRA for each of your daughters. You can invest a sum of money equal to what they've earned working. So if they baby-sit, that counts. If they do household chores and get an allowance, that doesn't count. Parents with small businesses can pay children for work, but this must be real work at reasonable pay, not $1,000 for stuffing 25 envelopes.

The beauty of a Roth IRA is that if you follow the rules, you don't have to pay taxes on any money or earnings generated in the account while it sits there, or when you remove funds after age 591/2. And you can withdraw contributions anytime you want, without taxes or penalty. That doesn't apply to earnings, except in certain cases.

Of course, you suggested your girls might use the money for a home down payment early in their adult years. And removing money at age 25 doesn't mesh with the rule that requires people to leave Roth IRA earnings untouched until they are 591/2, or face a possible penalty.

But the tax rules provide a few exceptions on Roth IRAs that should fit your daughters. People are allowed to take earnings out of Roth IRAs penalty-free at any age to pay for college, and they can remove $10,000 for a down payment on a first house provided the money has been in a Roth for at least five years. But if they withdraw it for other reasons before age 591/2, they would have to pay taxes on any investment gains or interest they take out.

In a Roth, you must also choose appropriate investments. When I showed you the power of investing $1,000, I illustrated the point by assuming a 9.5 percent average annual gain in the stock market. And for a 12-year-old, who will be investing for more than 50 years, a stock market investment makes sense. But if the goal is to build money for a home down payment, you should be cautious about stock market risks. The rule of thumb: Never put money in individual stocks or in a mutual fund that invests in stocks if you will need the money within five years.

Consequently, if you seriously think your daughters will be using the money for a down payment, you will want to be more conservative with investments, perhaps using a "balanced fund," which invests money about 60 percent in stocks and 40 percent in bonds.

You could consider funds such as the Vanguard Balanced Index (VBINX) or the FPA Crescent fund (FPACX). Then, when your daughters are about five years from needing a down payment, money should be shifted into a money market fund. This can be done within the Roth IRA. Meanwhile, money intended to stay invested until retirement can go — at least while the girls are still young — 100 percent into the stock market, perhaps through a fund such as the Vanguard Total Stock Market Index fund (VTSMX).

gmarksjarvis@tribune.com. Twitter @gailmarksjarvis.

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