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What’s the best gift for a newborn baby? How about retirement security?

Earlier this month, my wife and I were delighted to welcome a new granddaughter into the world, and we wanted to give her the very best gift that we could.

My readers won’t be surprised to learn that this meant a contribution to her long-term financial security.

But for someone who’s only days old and who could live well into the 22nd century, this is a formidable challenge. The actuaries say this little girl has a 50-50 chance to live to 100.

Her parents — my daughter and her husband — have good earning power. My wife and I assume our granddaughter has inherited their brains and good sense and that she’ll be able to support herself financially.

We decided we would make a one-time gift of $10,000 that’s intended to become a meaningful supplement to whatever retirement savings our granddaughter creates for herself. Think of it as a pension, if you like.

It’s not hard to figure out (mathematically, at least) how to fund an initial gift to a grandchild. I described one possibility early in 2022, this alternative in 2019, and another variation in 2015.

However, our good intentions face three major challenges, none one of which is really in our control.

  • First, how to avoid significant taxes on the growth of this money.

  • Second, how to make sure the money remains invested properly long after we’re gone.

  • Third, how to keep our darling little granddaughter from “raiding” the money prematurely.

First challenge: Taxes

As far as I know, the best vehicle to eliminate taxes is the Roth IRA.

However, our granddaughter is not likely to have taxable income this year to make her eligible to contribute to an IRA for 2022, and we can’t count on that for many years. Meanwhile, our $10,000 gift will be in a separate taxable account owned by my daughter with taxes due on dividends and possibly capital-gains distributions.

Even though it will significantly reduce investment returns, those taxes will be paid from the account itself. If my daughter and her husband decide to pay some or all of the taxes, that will be a great supplemental gift. But they won’t be under any obligation to do so.

As soon as our now-baby granddaughter has earned income that makes her eligible, the account will start funding a Roth IRA to the maximum amount allowed. However, every dollar that goes into the IRA will be taxed. If the $10,000 grows as I hope it will, that Roth funding could take many years.   

Second challenge: Investment allocation

Based on everything I know about the last 100 years of market history, my investment advice is simple: an all-equity portfolio split equally between the S&P 500 index
SPX,
+0.48%

and an ETF of small-cap value stocks. That is easy to implement, easy to manage, easy to understand, and likely to produce good long-term results.

However, even if I could somehow dictate this investment mix for the next 100 years, I’d be a fool to do so.

In 1922, mainstream investment advice might have called for buying railroad and utility stocks, putting the certificates in a safe place, and living off the dividends. But anybody who locked that strategy in place for the next 100 years would have given up the later innovations of mutual funds, index funds, self-service online brokerage accounts, IRAs and much more.

There’s no way to completely solve this challenge. But by the time our granddaughter is an adult and owns an IRA, my suggested investments presumably will have performed well enough to convince her that they are worth continuing.

Third challenge: Long-term patience

Perhaps our greatest concern is that our granddaughter will withdraw the money from her IRA and spend it. Ultimately, we cannot prevent this, so we have to take a leap of faith.

My wife and I have written a letter to be given to her when she’s old enough to understand this gift and its intent. We have included some of the things I’ve written, and we’ve recorded an audio message outlining our hopes for her, and for this gift.

We are confident that my daughter and her husband are likely to reinforce our message. That will be especially important to (my wife and I hope) dissuade our granddaughter from taking money out of the IRA early in order to do any number of things that young people like to do.

Ultimately this will be her choice, as it should be.

The potential results

Now let’s look at some numbers. I understand that projecting anything 100 years into the future is flirting with fantasy. But stick with me, and you’ll see that my head isn’t entirely in the clouds.

From 1928 through 2021, the S&P 500 compounded at 10.2%, and small-cap value stocks at 13.4%. I’m going to start with the assumption that, before taxes, my prescribed 50/50 combination will compound at 12% over the years.

In order to project the eventual results, I made a number of other assumptions that I won’t bore you with here and received generous help from Daryl Bahls, director of analytics at the Merriman Financial Education Foundation.

Result: When our granddaughter is 65, her IRA could have enough assets to support a 5% distribution of about $543,000 to help fund her supposed first year of retirement.

I say “help” because in 65 years from now, $543,000 won’t be worth what it is today. Not by a long shot.

If inflation in this country continues at its long-term rate of 3%, that would give her about $79,000 in today’s purchasing power. And at least under current tax laws, that will be tax-free.

That’s not enough by itself to let her live in luxury, but certainly enough to make an important difference.

This plan will require no monetary input from our granddaughter. In fact, what it WILL require is that she essentially do nothing!

If she can do that, I think our gift this year will end up being a winner. In the long run, it could turn out to be the best gift we could ever make.  

For more details about this investment and how I intend it to work, check out my latest podcast and a separate video, both titled “The best investment my wife and I will ever make.”

Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement. Get your free copy.

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