The Individual Retirement Account gets plenty of press about this time every year. The reason is obvious. An IRA is one of the few truly worthwhile tax breaks left to the average investor. In fact, an IRA may be the most valuable investment vehicle available to many people.

Nevertheless, I suspect most of our readers think IRAs don't concern them very much. After all, IRA contributions are limited to $2,000 a year and are tax-deductible only to people with relatively low incomes or no other pension plan coverage. But in fact, IRAs are under-used because so many investors don't know how to take full advantage of them. This month, we'll review some of the standard advice about how to use IRAs and answer questions from readers. But first I want to show you how you can turn an IRA into a virtual gold mine for making a gift to a young person.

BEYOND THE BASICS: THE GIFT OF A LIFETIME

Most people never think about one of the most spectacular uses for an IRA: giving a young person a tax-deferred gift that isn't likely to be squandered. This is a gift that can multiply your giving powers many times over. Even very small amounts, if left to grow over enough years, can mature into incredible sums.

Here is a real-life example: Suppose I have $2,000 in capital that I intend to leave to my daughter, Julie, when I am gone, hoping she will use it for a retirement nest egg. Basically, I have three choices. 1. I can simply write a check to Julie for $2,000. That gets the money out of my estate for tax purposes and transfers the tax liability for earnings on the $2,000 to her and her lower tax bracket. However, I cannot do this with any assurance that the money will be there for her retirement. She could spend the money or give it away as easily as she can invest it. 2. I can keep the money in my estate and invest the $2,000 in a no-load mutual fund, then leave that fund account specifically in my will for Julie. There is no tax advantage for me in doing this, however. 3. I can put that $2,000 into an IRA in Julie's name. (Assuming, of course, that she has at least $2,000 in taxable income this year and that she has not made her own IRA contribution.)

This third option, which I am about to describe, shows off the real power behind an IRA. It has tax advantages for me and for Julie. It will grow to a much, much larger sum for her than if I had taken the second option and invested in a mutual fund in my own name.

Let's start by tracing that $2,000 if it stays in my estate for 30 years. Assume I invest it in a no-load fund with a compound rate of return of 12 percent. Every year, that return is eroded by income taxes, let's assume the rate is 40 percent. That brings the after-tax yield down to 7.2 percent. Still, over a period of 30 years, that $2,000 grows to $16,102. However, at my death that $16,102 is subjected to estate taxes. Let's estimate them at 50 percent, which leaves only $8,051 for Julie. (If I had paid the 40 percent taxes out of other funds every year, her final bequest would have been much greater. But that would have cost me much more money over the years, and I want to show the effect of a one-time gift of $2,000.) So in this scenario, Julie winds up with $8,051 after 30 years.

Now imagine that instead I give Julie $2,000 invested in an IRA. Assuming the same 12 percent compound rate of return, with taxes deferred, her modest IRA grows in 30 years to $59,920. If she withdraws the money at that time and pays taxes on it at 40 percent, she is left with $35,952, or about four and a half times the $8,051 she would have if I had not given her the gift of an IRA.

But I am not sure the story stops here. Let's assume that Julie in either case continues to invest in this no-load fund, earning a compound rate of return of 12 percent for another 10 years until she is ready to retire. Starting with $8,051 and paying taxes on her earnings every year, she would wind up with $16,136, after taxes, 40 years from now. That's not bad from a start of $2,000. But if she had an IRA and kept the money there for an extra 10 years, that initial $2,000 would grow to $186,101, before taxes. Even after paying 40 percent taxes on that money she would have $111,661.

If we assume that at retirement Julie invested in a slightly more conservative way and achieved a 10 percent return, living off of the income, the fruits of a $2,000 gift today could provide her either (if the money stayed outside an IRA) $1,614 a year ($134 a month) or (if the money was in an IRA the whole time) $11,166 a year ($930 a month).

If you were giving the gift, which outcome would you prefer? Incidentally, the IRA scenario could be even sweeter if Julie pitched in, at no cost to herself, in the year she received the gift. That's because she would get a tax deduction for your $2,000. At an assumed tax rate of 15 percent, that's $300 that she could invest in the following year's IRA and it would boost her ultimate result by 15 percent.

I hope this discussion leads you to imagine some possibilities. Think what a gift of $2,000 into an IRA every year could do for Julie's retirement. Granted, the most spectacular results would come from the earliest contributions because they would have the most time to compound tax-free. But let's look at what would happen if Julie's dad (me) was willing and able to make 10 consecutive gifts of $2,000 a year. If Julie left the money to compound at 12 percent a year until 40 years after the first of those gifts, my initial investment of $20,000 would grow to a staggering $1,177,698 before taxes. Assuming she took all the money out at once and paid 40 percent taxes on it, she'd still have $706,619. That's enough to give her a monthly income at retirement income of $70,662 a year or $5,888 a month. All from an initial investment of $20,000! And if she left most of the money in the IRA while she made her withdrawals in retirement, she would do even better because she would not have to take a one-time tax hit of $471,079.

I hope the point is clear. If you are a parent or grandparent and you want to give a young person the gift of a lifetime, give money into an IRA. If you can't afford $2,000, give what you can. Even $500 is significant. If you gave $500 a year for 10 consecutive years, your gift could grow, under these assumptions, to about $294,425 (before taxes) in 40 years.

And if you are taking the common estate planning advice to make gifts during your lifetime to your heirs in order to avoid estate taxes, consider buying an IRA instead of just writing a check.

 

 

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