Building A Roth IRA For Kids

Includes: ABT, ADP, AFL, LOW, NUE
by: Dividends Paid

In my last article I discussed how I am going to help my son get a head start in investing and how to keep him interested in dividend growth stocks as he gets older. I am excited about the potential of this plan; the only problem is that the government is going to get their share of it as well. If you are reading this then I assume you are not a Communist that enjoys paying taxes, so I'd like to show how you can grow a small amount of money for your child into a very large sum without having to worry about a politician getting their hands on one cent.

For those of you not familiar with a Roth, shame on you, please read this article. Roth IRA's are a powerful retirement tool that is not utilized enough by individuals who have the opportunity to do so. What is utilized even less - and likely unknown to many - is funding a Roth IRA for a child.

Like most adults, a child can put up to $5,000 into a tax-sheltered Roth IRA each year. The one caveat being that all funds contributed to the Roth IRA must be earned income by the kid. Does that earned income include interest from a CD that grandma bought him? No. Does that earned income include dividend income from a custodial account that a smart, handsome father started for him when he was a newborn? Sadly… no. Only income that is earned through a job can be contributed.

The good news is that the IRS does not care if a parent makes that contribution out of their own pocket while the child spends their hard earned money on things they care about. So when my son is a teenager and gets his first part-time job (that Uncle Sam is aware of), I hope I am able to match every single dollar that he earns and put that money into a custodial Roth IRA. Being able to do this for him at such a young age will allow him to take advantage of the all-important "time" aspect of dividend growth investing. Add in the fact that his compounding growth will be tax-free and you have a potent retirement account established before your child starts their career.

Just how powerful can this be? Let's assume you could contribute a total of $5,000 to your child's Roth IRA by the time they are 20 years old. You invest this money into dividend growth stocks and set your (tax free) dividends to reinvest. With an average annual dividend growth rate and price growth of 8%, that $5,000 will grow to the following:

Year Starting Balance Dividends Growth Total
1 $ 5,000 $ 150 $ 400 $ 5,550
20 $ 36,316 $ 1,090 $ 2,905 $ 40,312
30 $ 103,118 $ 3,094 $ 8,249 $ 114,461
40 $ 292,797 $ 8,784 $ 23,424 $ 325,004
45 $ 493,379 $ 14,801 $ 39,470 $ 547,651

Now what if your child learned from the great example you set and made regular, monthly contributions of $100 into his account after you stopped contributing.

Year Starting Balance Dividends Growth Total
1 $ 5,000 $ 150 $ 400 $ 6,750
20 $ 104,644 $ 3,139 $ 8,372 $ 117,355
30 $ 317,195 $ 9,516 $ 25,376 $ 353,287
40 $ 920,717 $ 27,622 $ 73,657 $ 1,023,196
45 $ 1,558,935 $ 46,768 $ 124,715 $ 1,731,617

This is using an 8% dividend growth rate, consider the possibilities if your annualized dividend growth averages over 10% as these stocks have over their lifetime:

Abbot Laboratories (NYSE:ABT) - a diversified life science company that is a leading maker of drugs, nutritional products, diabetes monitoring devices, and diagnostics.

Current Yield 3.4%
Annualized Dividend Growth Rate 12.6%

Automatic Data Processing (NASDAQ:ADP) - is one of the world's largest independent computing services companies, providing a broad range of data processing services.

Current Yield 2.9%
Annualized Dividend Growth Rate 14.3%

AFLAC (NYSE:AFL) - provides supplemental health and life insurance in the U.S. and Japan.

Current Yield 2.7%
Annualized Dividend Growth Rate 16.4%

Lowe's Companies (NYSE:LOW) - sells retail building materials and supplies, lumber, hardware and appliances through more than 1,700 stores in the U.S. and Canada.

Current Yield 2.0%
Annualized Dividend Growth Rate 15.9%

Nucor Corporation (NYSE:NUE) - is the largest minimill steelmaker in the U.S., and has one of the most diverse product lines of any steelmaker in the Americas.

Current Yield 3.3%
Annualized Dividend Growth Rate 18.1%

If you are fortunate enough to match your child's earnings, you can tell them that they are effectively making double their current hourly rate. Sure, they may be disappointed about not having that cash in their pocket now, but this should still be a motivating factor to work even harder.

There is one negative you should be aware of. A child's retirement account can affect the amount of college financial aid they qualify for.

Of course we can't trust politicians to change the rules for Roth accounts, but I think it would be a kiss of death for getting reelected. And we must do our best to teach our children to not withdraw money from their retirement account prematurely.

So if you have a teenager who has earned income in tax year 2011 you should consider opening a Roth IRA for him or her. You have until April 15 to make a qualified contribution for the previous tax year. Hopefully this option will still be available in about 16 years for my son as well.

Disclosure: I am long ABT, AFL.