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Start retirement plans early

It’s never too early to start planning for retirement, even if the retirement plan is for someone who’s currently more concerned about high school dances and ballgames than the work world.

If you establish an IRA for your children or grandchildren, you can help them achieve financial independence in retirement. With enough years of tax-deferred compounding of investment earnings, an IRA can yield some amazing numbers.

While you must set up and serve as custodian of the IRA until your child reaches majority, your child is the “owner” of the IRA and is subject to all the income requirements and rules.

The maximum allowable contribution for 2006 to a traditional IRA or Roth IRA is $4,000. (If you are age 50 or older, you can contribute up to $1,000 more.) But there is a catch, and it’s especially relevant for children. If the IRA owner’s earned income (income from wages, not from investments) is less than the maximum contribution amount, the contribution is limited to the income that he or she earns.

Billy and Susie don’t have to give up the paychecks from their part-time jobs for retirement savings. You can contribute the money by making a gift to your child up to his or her earned income. The annual gift tax exclusion ($12,000 in 2006) shelters your gift from tax.

Now keep in mind, paying your child an allowance for helping out at home isn’t likely to be “earned income” and survive IRS scrutiny. A regular paycheck from a business, on the other hand, clearly qualifies. Check with a First Tennessee representative to see which specific situations qualify, and make sure you and your child keep careful records of all earnings.

When deciding which type of IRA to use, a Roth IRA generally is considered to work best for children. Withdrawals from a Roth IRA are tax-free, provided that all the conditions are met, and there are no required distributions when the owner reaches age 70 1/2.

While contributions can be withdrawn tax-free at any time, for the earnings to get the preferential treatment, a Roth IRA must be owned for at least five years and the owner must be at least age 59 1/2.

A traditional IRA allows pretax contributions, but tax is owed on withdrawals. That may not be a big benefit when your child is relatively young and owes little or no tax on that income. Both IRAs permit penalty-free withdrawals for education expenses and $10,000 in home-buying expenses for the first residence purchased.

Here’s an example of how relatively small contributions can add up for your child, using a hypothetical 6 percent investment rate of return a year:

If you open an IRA for your 16-year-old son and contribute $3,000 a year for six years, he’ll have $20,926 in the IRA at the end of the six-year period. Even with no further contributions, he’ll have $36,526 in the IRA 10 years later and $249,860 in the IRA when he reaches age 65.

Of course, you’ll want to encourage your child to continue making contributions to the IRA throughout the years. And be sure you talk with your child about the importance of this investment because once your child reaches majority, he or she can take funds from the IRA or even close it out. If all the Roth IRA conditions aren’t met, in addition to tax on the investment earnings, penalties could apply.

Jeff Francis is senior vice president and senior investment officer for First Tennessee Brokerage. For more information about this or other personal finance issues, call 865-971-2321.


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