The Summer Worker

Savings for your child or grandchild

There may not be many feelings better than being at work at an ideal job and being paid to do it.     James Cole has always felt enthusiastic about his work and he knows the value of a dollar.    James is a father and grandfather who built a family business is St. Louis, a full-service hardware store, that survived the big box takeover of the tools and nails market because James was always a believer in customer service.   Trained front-of-store employees, shiny clean aisles, and in-store trade professionals who can offer a solution to a leaky toilet and the right saw to cut a gutter downspout. James’ paid his employees well and all knew they were members of a “team,” long before management consultants adopted the term. Hot, humid St. Louis summer days would often turn into a liquid cool down with all the associates. Bud Light in an ice cold glass is James’ favorite drink. What he hears about the Dylan Mulvaney promotion not so much.  

Social media isn’t important to James.  “I’ve got five hundred customers like my buddy Michael who need simple problems solved. The right fitting for a drip irrigation project or an effective ant killer. These customers would never find us online. Our Michaels’ know from word-of-mouth that we will solve their problem when they visit us.”    James Cole is old school because old school has worked.   Git ‘er done, face-to-face guys don’t have room for social media campaigns.   They have wisdom and experience on their side. 

James, Elizabeth, and Savings

James is one of the more benevolent of his lot with good intentions to share unsolicited advice with his children and grandchildren on all matters.   James and his eldest granddaughter Elizabeth are especially close. Elizabeth grew up in Ladue and now attends Wash U. At a Cole family Sunday afternoon picnic James had Elizabeth in his sights.  “Elizabeth, are you saving any money from your job?  You should be doing that?  “Haven’t thought about it Papa, Elizabeth said.” “I like going out with my friends.”  Time to get the habit is James’ thought.  Another old school principle. 

Elizabeth does have a plan.  A junior, she is working retail at Kendra Scott near the Zoo for a summer job and her path is lofty.   Ph.D. in molecular cell biology is Elizabeth’s education future then an academic life chasing research grants offered by the NIH.  Fortunate is Elizabeth who can treat any job now as extra money because James has funded the college education of his five grandchildren. But, grandfather is involved and his opinion needs to be weighed. Elizabeth thinks: “should I save something?” “Save a little, spend a lot?” “Where should I save if I want to do that?”

Savings and the Summer Worker

As readers know, savings is an output in organized financial planning, but then how can we deny the affirmingly wise and loving octogenarian and his unwavering opinion about the habit of saving? James’ knows Elizabeth is just fine whether she saves or not, but let’s suppose he wants to offer an intra-family incentive plan: contributions to Elizabeth’s saving to promote his interest in the habit.

To my students, those who would like to save and are working in summer internships, I always suggest a Roth IRA. Mostly because food, shelter, clothing, and fun is covered by the family. Yes, a Roth is a retirement planning vehicle. But, it can jump start the habit of saving with some remarkable flexibility. The tax law also permits a relatively large contribution relative to actual earned income for the Elizabeth’s of the world who are still in school and economically dependent. In other words, if Elizabeth plans on making $5,000 this summer at Kendra Scott she can contribute $5,000 to a Roth. James can help that along, too, by offsetting directly Elizabeth’s contributions with a gift. Or, just funding it directly.

The Flexibility of a Roth IRA

The primary benefit of a Roth as a retirement vehicle is that when Roth investment assets are sold and converted to cash there is no capital gains tax consequence, unlike if the same financial assets were held in a brokerage account. A Roth fits into the class of a retirement savings vehicles with tax advantages and seemingly no withdrawals until 59 1/2 that can be an impediment to savings for those in their late teens and twenties. A typical reaction: “I don’t have a full-time job and you want me to think about retirement?”

In practice, there is more flexibility to a Roth IRA than one might think.

Suppose Elizabeth has two years of summer employment in which she earns $5,000 per year. There will be some tax, but Elizabeth’s after-tax amount leaves her with an ample quantity of earnings to spend. James’ supports Elizabeth and his interest in promoting savings by funding Elizabeth’s Roth each year to the tune of $5,000. Perfectly legal. Formalize a Roth with an investment company and invest the contributions in a low-cost, well-diversified total market portfolio like Vanguard’s (ticker: VTI) and the fun begins. Bingo.

Elizabeth will leave her undergraduate days with a Roth IRA with total value $10,000 in contributions plus investment returns. Elizabeth can dispense back the $10,000 of contributions at any time if she needs funds, but otherwise savings is underway. Special to the Roth is that investment returns grow income tax-free and up to $10,000 of investment returns (a “qualified distribution”) can be pulled out for a first-time home purchase if the Roth has been setup for five years.

Bachelor’s degree in hand, Elizabeth would be two years into the five-year Roth time requirement. What are the chances that Elizabeth has a good investment outcome? Let’s play what-if. At age 21, Elizabeth’s Roth has been active for two years and has earned modest returns. The account value is $10,800. In the chart below, I have projected the range of potential values from today forward for Elizabeth’s Roth IRA if Elizabeth invested in Vanguard’s total market index fund. Forecasted account values are simulated based on historical risk/return traits of VTI and contrasted with a T-Bill that will earn 3% per year.

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The heavy orange line shows the path of the Roth IRA if the $10,800 is invested at 3% per year. The 10-year value of the account if invested in a very low risk alternative is $14,514.

The risk of the VTI portfolio is obvious from the account value paths of the 100 different simulations given VTI’s historical average return and risk of those returns. It is, of course, much riskier than T-bills and not a strictly comparable alternative investment, however, it can be informative for someone like Elizabeth. At the 10-year mark, more than about 75% of the time, the Roth account value is higher than $20,000. Less than 10% of the time, the Roth account invested in VTI will have a value lower $14,514.

The chances of Elizabeth having $20,000 for a down payment toward a home are high. $10,000 of contributions and $10,000 of investment returns without a tax consequence. There is another near-term, non-retirement benefit for Elizabeth among the kickers that make a Roth attractive.

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   Roth funds can be withdrawn to pay for Elizabeth’s future educational expenses or for those of a future spouse or child and the 10% penalty is avoided. There may be a tax consequence on any investment earnings that are part of the withdrawal, however.   

Two last words on the value of a Roth: tax diversification. There is risk to the future prospects of income tax law and income sources differentiated by their tax treatment. Weighing tax effects of contributions, investment accumulations, and withdrawals is an opportunity for thoughtful financial planning. Most longer term savings interests are motivated by retirement. James is living it now. Elizabeth will live it someday. If a Roth is used as intended, distributions after 59 1/2 to support the living standard will not be taxable. Any 401(k) distributions and part-time work earnings will be taxable events. The details matter, but the intentions of James are simpler: good habits give Elizabeth a better chance for a good financial life.

1. Over the last 10 years, this Vanguard fund has had an average, annual return of 11.68% and a standard deviation of returns of 15.25%.

2. You can find details and IRS guidelines here.