The Benefit of Setting up a Roth IRA for Your Child
Did you know that Roth IRAs for kids are a flexible way for you to help them start saving for retirement as soon as they begin earning income?
When you think of a Roth IRA, you don’t usually picture a child as the owner. But, when you dig deeper, a Roth really is an ideal savings vehicle because they have more than a half-century to watch their contributions grow tax-free. Plus, there is a great deal of flexibility allowing you to withdraw your contributions at any time without tax or penalties.
Here are some facts that you may not be aware of that could make setting up a Roth for your child a no-brainer.
- Savings at any age. No matter how old or young your child is, they can contribute to a Roth IRA as long as they have earned income.
- Parental Involvement. Either a parent or other adult must open the Roth IRA for a child.
- Flexible Convenience. Unlike other retirement savings accounts, you can withdraw funds from your Roth IRA without penalty. This could also make it a vehicle for college savings, first home savings, wedding, baby, etc.
It is important to learn the rules about opening a Roth IRA for a minor and determine whether this savings vehicle is the right one for your child.
- Earned Income. If a child has earned income, then he or she is eligible to contribute to a Roth IRA. The IRS defines earned income as taxable income and wages – this could be money earned from a W-2 job or from 1099 wages from baby-sitting, tutoring or from modeling or acting work. Whatever way your child earned his or her income – if they file taxes, then they can contribute to their own Roth IRA.
- Yes, you can contribute. Parents and other adults may contribute to a custodial Roth IRA as long as that contribution does not exceed the earnings made by the child.
- Contribution Limits. Just as with a standard Roth IRA, the 2023 Roth IRA contribution limit is $6,500 per year or the total of the earned income for the year- whichever is less. This is an important distinction especially if you’d like to match your child’s contribution. If a child earns $1,000 in 2023 for dog-walking, then the maximum amount that she can contribute to the Roth IRA is $1000. So, if she chooses to contribute the entirety of her earnings to her Roth, then you will not be able to contribute as well.
HOW-TO & WHY
In order to open a Roth IRA for your child, you’ll need to provide social security numbers, birthdates and other personal information for you and your child (or the child for whom you are opening the account). The process is fairly simple and should only take about 15 minutes.
If, after reading this, you have determined that your child is eligible to contribute to a Roth IRA, you might now be wondering if it is really the right vehicle for them to save with. While there are a great many mitigating factors to each family’s unique circumstances that will determine the answer to that question, consider the following when making your choice.
Investing is Better than Saving
While savings accounts are great for kids and still have a place (for birthday checks from Grandma) investing in a Roth has the potential for long-term growth that will (likely) outpace inflation and grow tax-free for decades. Yes, savings accounts have a small interest rate (on average about 0.09%) but don’t have the interest-earning potential of an investment account.
As you invest, compound interest is very powerful when put to work at a very young age. With more time, the money you invest makes you more money. While most of us have around 30 years to save for retirement, children have a whole lot longer and if they begin investing their earnings early, they could be looking at tax-free growth for upwards of 50 years. Even if they had a few years during college when they were unable to contribute, the investment that already existed would continue to grow during that time.
Consider the following example. "Let's say [your teen] puts $1,000 of his summer earnings into a Roth IRA for each of the four years from age 15 to age 18. If he stops and never puts in another penny, but lets the money grow, by age 65 he'll have about $107,000, if the money earns 7% a year.
But if your kid waits until age 25 and then puts away $1,000 for each of the four years until age 28 and stops, that account will only be worth a little over $50,000 by age 65."
Double the Tax Savings
Unlike a traditional IRA or 401k, Roth IRA contributions are made after taxes have been taken out of your earnings. For children whose tax rates are extremely low, because they are not likely making much money, they may be paying little or no income tax on their earnings. Since you pay no tax on withdrawals that you make from your Roth IRA, children may experience the great benefit of paying zero taxes on their investment on either side of it.
More than just Retirement Income
It goes without saying that Roth earnings can be used for retirement, but because of the flexibility of Roth Accounts, there are many ways in which contributions can be used. After funding a Roth for at least five years, you may take up to $10,000 out to buy a first home without tax or penalty. Roth IRA earning may also be used without penalty to fund qualified educational expenses, though the earnings distributed will be taxed as income.
Saving for retirement can begin at any age. Teaching your children how they can grow their wealth as soon as they begin earning money is a phenomenal lesson and truly a gift that keeps on giving. For this and any other financial decisions, you may like to consult a financial advisor. We are happy to meet with you in person or over the phone to discuss your options and help you grow your wealth (and your children’s!). Please feel free to contact us to schedule a complimentary phone discussion or in-person meeting.
You may also be interested in learning more about The Mega Roth IRA.
About the Author
I am a life-long MA native and live in Andover with my wife Nadine and our two daughters. When I am not in the office, I keep busy taking the girls to dance class and going on family bike rides. Nadine and I enjoy a night out on the town following our favorite DJs and bands, cutting a rug to the soul, disco, and R&B that we love.