This summer a client’s teenage daughter is going to have her first job. Her parents are excited for her to gain some valuable work experience and earn some extra spending money, they also plan on using her paycheck as an opportunity to teach her to save and invest for the future.
Teaching our children smart saving habits should be a priority, although it can be easier said than done! We’ve found that one of the best ways to teach children is to have them practice saving up for a goal or contributing to a savings account. One vehicle to achieve this objective is to open a Roth IRA for my daughter.
What is a Roth IRA?
A Roth IRA is a retirement account to which you make contributions with after-tax dollars. Different from a traditional IRA, deductions to a Roth IRA are not tax deductible, however, qualified distributions will be tax-free once you’ve met certain requirements.
Due to this feature, a Roth IRA can be an ideal investment vehicle for younger investors who are currently in a lower tax bracket and expect their tax bracket to be higher in retirement.
Can my child open a Roth IRA?
If your child has reportable earnings to the government, he or she can contribute to an IRA regardless of his or her age. Reportable earnings need to be reported on a W-2, so babysitting and monthly allowance will not count.
If your child is a minor, you will have to open a custodial account, which will give you control of the assets in in the IRA until your child reaches the age of 18 (or 21 in some states), at which time you will have to turn the assets over to him or her.
How much can my child contribute?
Contributions cannot exceed:
- $5,500 OR
- his or her taxable compensation for the year.
For example, if your child makes $2,000 over the course of the summer, he or she can only contribute $2,000. While it might be difficult for your child to part with 100% of his or her paycheck, monetary gifts from grandparents or other relatives can be contributed as long as the total contributions don’t exceed his or her taxable income or $5,500. I’ve even heard of some parents offering a match to incentivize their children to save more.
Note: There are additional contribution limitations if one’s modified AGI is more than $184,000. Go the IRS website for more information about contribution limits.
What is the benefit of helping my child start to invest at a young age?
In addition to acclimating your child to the idea of investing and not spending his or her entire paycheck, the sooner your child begins to invest, the more likely he or she will achieve financial independence.
Take for instance the chart below that illustrates investing $2,000 per year with a 6% rate of return. By beginning to invest at age 15, retirement savings could grow to $615,512, compared to $328,095 if one begins saving at age 25.
Note: This is a hypothetical example and does not reflect the performance of any specific investment. Results assume reinvestment of all earnings and no tax.
Will a custodial Roth IRA affect my child’s eligibility for financial aid?
No, neither you nor your children’s qualified retirement are considered assets that could affect financial aid eligibility.
However, if you or your child take a distribution to pay for college, the amount withdrawn could be considered income and affect your ability for financial aid the following year. Read more about retirement plans and saving for college at finaid.org.
We want to help you and your family grow smarter. If you have questions about setting up a Roth IRA for your children, contact us to see how we can help you and your children prepare for your financial goals.