How to Give Your Child $1 Million Tax-Free

One of my client's families asked me how to get their 20-year-old daughter, Susan, started on a lifetime of investing. They asked specifically about savings bonds because conventional wisdom says that savings bonds are a “safe”
investment.

It’s true that savings bonds are a safe investment. But their safety comes at a cost. Savings bonds produce about a 1% annual rate of return. They grow steadily, but at a snail’s pace — certainly not enough to illustrate the long-term value of investing.

At a 1% annual rate of return, the value of the savings bond would double after 72 years. I said, “I’ve got a better plan for your daughter.” For the past year, she had been working part-time after school and had made about $10,000. That income enabled us to open a Roth IRA in Susan’s name and contribute $6,000.

The rules on Roth IRAs state that you can contribute up to $6,000 per year, as long as your income exceeds your contributions. The rules do not say where the contributions have to come from.

Susan received no tax break today for making the contribution to the Roth, nor would her parents. However, the funds invested in the Roth grow tax-free for life, and withdrawals (which could start at age 59 and a half) are also tax-free.
Obviously, $6,000 per year initially didn’t seem like a lot to my clients. They asked me, “What does $6,000 really do for her?”

I explained that if they contributed $6,000 per year for 20 years, they would make a total contribution of $120,000 to Susan. If the investments averaged a 7% annual rate of return (which we have seen in index ETFs over the past 20 years), those contributions would more than double to $250,000 by the time Susan turned 40.

If the parents made no further contributions after the 20th year, but the investment returns remained around 7%, the funds would double to $500,000 10 years later, and double again to $1 million 10 years later when Susan was 60 and eligible to take distributions. So, $120,000 invested at a rate of $6,000 per year for 20 years would ultimately be a gift of $1 million tax-free.
The parents said, “Sign us up!”

Wealth doesn’t come from gambling — it comes from compounding

One of the most important elements of successful investing is understanding the power of compounding. The calculations I made above are based on the Rule of 72.

The Rule of 72 is a simple calculation that shows you how long it will take your investments to double in value. In the above example, we assumed a 7% annual rate of return. Consider that 72 divided by 7 equals 10.3, meaning my clients’ daughter’s Roth IRA contributions would double in value approximately every 10 years. At a higher average rate of return — 10% — the calculation changes: 72 divided by 10 equals 7.2. If the markets average a 10% annual rate of return for 7.2 years, which is not unheard of, the investments] double approximately every 7 years.

Many amateur investors think investing is like gambling. Headline-grabbing events like the GameStop rally and the Bitcoin rollercoaster make people think that investing is all about finding rocket ship assets, riding them to their peaks and making huge returns in a very short period.

That rarely works. Buying those stocks is essentially the same as playing roulette: an adrenaline-driven, low-odds gamble.

Embrace the power of compounding by taking the boring, unsexy, long view

An oft-repeated quote from Warren Buffett goes, “Benign neglect, bordering on sloth, remains the hallmark of our investing process.”

It doesn’t mean Buffett is not a conscientious investor — you don’t get to $100 billion in wealth by being thoughtless. It means that when Buffett buys, he buys for keeps. Here are a few tips for investors looking to build true wealth over the course of their lives.

Avoid Catastrophic Mistakes

Let’s say you have $10,000 and you want it to grow quickly. You make a risky investment. It doesn’t pan out. You lose half and are down to $5,000. To try to recover from your loss, you make another risky investment. Well, that investment doesn’t work out either and now you’re down to $2,500.

Worn out from the losses, you decide to take the more passive approach, letting the money grow through compounding. Knowing what we know about the Rule of 72, even a 10% annual rate of return will take about 15 years to get you back to $10,000. If you’d taken the steady approach from the beginning, that $10,000 would have doubled twice, to $40,000.

While the initial investments seemed to only cost you $7,500, they really cost you $30,000 in those 15 years.

The risk-reward profile of high-risk investments doesn’t make sense. Avoid any scenario with a good chance of destroying capital.

Be Careful Around ‘Fad Stocks’

Certain stocks achieve a high level of notoriety for reasons other than their underlying value. Tesla, for example, is well-known largely because of its well-known founder, Elon Musk. Musk is a provocative celebrity, much more outspoken and visible than many other entrepreneurs.

Be very careful around “fad stocks,” stocks that are very popular at any given time. When you buy high in hopes of selling higher, you succumb to the “greater fool” fallacy. If you don’t know who the greater fool is, you are the
greater fool.

Fads come and go. Value is not determined by popularity.

Embrace Unsexy Investments

Rather than going for fad stocks, amateur investors should favor very boring, adrenaline-free, plain vanilla investments like index ETFs. These investments yield consistent, solid rates of return, and aren’t subject to the same volatility as fad stocks.

True wealth comes from compounding, not thrill-seeking. I always tell my clients, “The first $500,000 is the hardest,” because it may take a while for their investments to double enough times to reach that benchmark. But, after that, the pace picks up considerably. As my clients age into their retirement years, they’re worth more than they ever thought was possible.

David Edwards is president and wealth advisor with Heron Wealth based in New York City and advises clients across the U.S. and around the world. Dustin Lowman contributed additional research for this column.