Roth IRA: A 'Long Game' Strategy For Your Child's Home Ownership Dream
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The 1946 film classic It’s a Wonderful Life is much more than a Christmas story – it’s really about American values and dreams. As head of the Building and Loan Company started by his father, protagonist George Bailey (Jimmy Stewart) works hard to help people in his community achieve their dreams of home ownership. In constant battle with Potter, the rich skinflint who wants to take over the town, Bailey asks Potter the vexing question, “Do you know how long it takes a working man to save $5,000?”
In the 72 years since the movie premiered, owning a home is still considered a step towards building wealth and achieving the American Dream. But affordability and entry to the real estate market can still be elusive.
The High Hurdle to Entry
America’s real estate market is highly valued and in areas like San Francisco, the median listed home price is now over $1.2 million, per Zillow. The 2017 Apartment List Survey found that 80% of Millennials want to own a home, but as many as 72% found cost the biggest challenge.
It’s a complex conundrum. Although interest rates are creeping up, they remain at historical lows, in the mid 4% range. The monthly mortgage payment is not the challenge - rather it’s the down payment. The ability to generate sufficient savings to put down money on a home keeps many young people from moving forward.
Many millennials are turning to their families for help. While parents should have appropriate financial boundaries, there are ways they can help their children, including gifting down payments or making loans. As with college and retirement planning, playing the long game is often the best way for parents to provide this support.
Playing the Long Game with a Roth IRA
One long-term strategy parents might consider is utilizing a Roth IRA for their children. Given the income limits on Roth IRA funding, it’s a great option for children once they start earning income. A Roth IRA is funded with after tax dollars of up to $5,500 (as long as the amount does not exceed the child’s earnings) and can be funded for tax year 2017 until April 17, 2018. The funds grow tax deferred and withdrawals are tax free in retirement (making a Roth IRA a powerful retirement tool.)
So how does it help for a first-time home purchase? You can always take out Roth contributions without taxes or penalty. However under the IRS rules, your child can take a distribution of earnings up to $10,000 from their Roth IRA for a first-time home purchase, without penalty and without taxes, provided they held the Roth for 5 years from the beginning of when it was set up. If you are under the 5 year mark, you don't pay penalties - just the tax.
For many taxpayers with children, this is a useful approach. Rather than trying to carve out enough for your child’s down payment while you are saving for, or are already in retirement, you have established a vehicle that puts funds at their disposal. In addition, your child might take advantage of the first time home-buyer program that allows for a 3% down payment. And if your child doesn’t buy a home – well then you have set them on a path of retirement planning.
The Strategy of Equalization
Assuming you have sufficient excess cash flow to fund the Roth IRA, at least in the early years, the strategy also enables you to maintain financial boundaries if you have more than one child. Typically, parents want to be fair and equal when it comes to helping their children. Setting up Roth IRAs for each child eliminates the need to decide parameters when the children are ready to buy their first homes and need help with the down payment. You can incentivize them early on by explaining that you will help fund a Roth IRA provided that they work, and encourage them to make good financial decisions, especially if they want to buy a house. The strategy works well as a tool to help them, while avoiding the need for you to disrupt your own finances.
With tax season upon us, this could be the perfect opportunity to fund a Roth IRA for your child, if they have earned income and are under the AGI threshold. The Roth IRA is a gift that keeps on giving and can help your child become a homeowner when that time comes.