“Did I ever tell you the story about the magic of compounding?”

That’s what you should ask your recent college graduate when you give her a Roth IRA contribution for graduation. It’s possible she won’t listen, but years from now she’ll be very grateful.

The power of the Roth IRA
A Roth IRA makes a great graduation gift because young people have the benefit of time on their side, allowing account earnings to compound over many decades. And the earnings in Roth accounts grow tax-free.

In order to be able to contribute to a Roth, the graduate needs to have income from work this year. That could be from a part-time or summer job, or from freelance work like babysitting. The maximum that can be contributed to the Roth is $5,500 or her total earned income, whichever is less.

The chart below shows how a single year’s Roth contribution could grow over time. It assumes one $5,500 contribution, an investment return of 6% per year, and no adjustment for inflation.

One of the benefits of giving a graduate a Roth contribution is that it can get them thinking about saving and investing. To encourage them, you could consider offering a match, whereby you put in $100 for every $100 they contribute, up to the permitted contribution maximum.

Not Really a “Gift”
Technically, you’re not really able to give a Roth IRA gift to your graduate. They will have to open the account. You can then give them the money, and they can deposit it into the account. Once the dollars are contributed to the account, it’s time to invest them.

Investing the Roth
For young people just getting started with investing, the options may seem overwhelming. Fortunately, the financial services industry is in the midst of a price war, and so the cost of investing continues to fall. Most large brokerage firms, like Charles Schwab & Co., offer a range of mutual funds and exchange-traded funds (ETFs) that can be bought and sold commission-free. And the ongoing management fees for the funds can be as low as 0.10% or 0.20% per year, or about $10 per year for a $5,500 Roth contribution.

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