Roth IRAs for Hardworking Teenagers: A Perk of Your Child’s Summer Job with Big Potential
If your child earns income, they are eligible to set up a Roth IRA, which is an extra perk from all that lifeguarding, ice cream scooping, lawn mowing and paid interning. While the financial jargon (IRAs, earned income, contributions etc.) can be intimidating, and it seems so early to think about retirement while kids are still in middle and high school, it’s worth understanding this great benefit. Not only do Roth IRAs accounts have great tax advantages, but they are also less restrictive than traditional IRAs. Starting a Roth IRA at such a young age means the account can compound value over decades, leading to a potentially meaningful nest egg. Opening an account for children early is an opportunity to have them learn about investing from a young age while developing a lifelong investment habit. It’s also an additional, less obvious reward for their hard work.
First, let’s talk about Roth IRAs and what they are. An IRA, or “individual retirement account” is a special type of financial account which allows individuals to save for retirement and gets special tax-advantaged treatment under U.S. law. There are traditional IRAs and Roth IRAs, which differ in the tax advantages and rules which apply to the accounts. Traditional IRAs are funded with pre-tax dollars and require minimum distributions from the portfolios at age 75, potentially triggering a greater tax burden for the account owner. In contrast, the key feature of Roth IRAs is that individuals contribute after-tax dollars to their accounts, and account owners aren’t required to take distributions, creating more flexibility. Most importantly, both types of IRAs grow tax-free over time. This may seem minor, but in fact it is a highly attractive benefit, as the accounts do not pay capital gains taxes (incurred when a security is sold for a profit). Withdrawals from Roth IRAs, if taken, are tax-free.
Invested over decades, your child’s Roth IRA will benefit from the power of tax-free compound interest over time, magnified by the effects of regular contributions. Compound interest is when both the initial investment and earnings on that investment generate additional earnings. This combined effect over decades of investing is a powerful combination.
While your child probably won’t understand the nuances or potential of these types of investment accounts, starting a Roth IRA account at a young age for them provides a turbocharge to your child’s future retirement earnings. Along the way, your child will develop healthy financial habits by investing a portion of their earnings regularly. As well, over time they’ll learn a key investment lesson: saving today creates more wealth tomorrow.
Note that there is some administration required. The initial account set-up is straightforward and will include some paperwork. If the child is younger than 18 or 21, depending on the state, the Roth IRA needs to be set up as a custodial account, meaning that an adult, typically a parent or grandparent, oversees the account. Once the child turns 18 or 21, the account can be transitioned to the young person. If your child doesn’t have W2 income from a paycheck, it’s a good idea to keep a spreadsheet of payments from babysitting, etc. Note that this type of income over a certain amount may count as self-employment income, which may be subject to tax. Allowance and birthday gifts don’t count, unfortunately. Filing a tax return for the child is also recommended.
Contributing annually to a Roth IRA, if your child has earned income, is important. Account owners (or anyone, including parents and grandparents) can make annual contributions totaling up to the amount of their earned income or $6,500 in 2023, whichever is less. Note that the contribution ceiling amount goes up each year. There is no age restriction, but the account owner must have earned income and fall under the Roth IRA income limits. These contributions, in addition to the tax-free growth of the existing investments in the account, accelerate the growth of the accounts.
There are a few catches: Roth IRAs are income-restricted, meaning that if you make over a certain amount of adjusted income based on your tax status, you aren’t able to contribute to a Roth IRA. Also, because the contributions to Roth IRAs are made with money that’s already been taxed, you don’t get a deduction on tax returns like you would a traditional IRA. This is typically not a problem for young people, as they’re often earning a limited amount of income and are in a low tax bracket anyway, so don’t need the tax deduction. Also, because the tax advantages of these accounts are in place to incentivize long-term retirement savings, there are some restrictions on taking tax-free withdrawals from the account before age 59 ½.
Roth IRAs can be a wonderful way to reward your child for their hard work while setting them up for future success. Most kids wouldn’t think of opening an investment account, much less one with seemingly complicated tax features, and as a result miss these key investing years. Giving them the gift of an early start by opening and contributing to a Roth IRA for them makes a world of difference, as the investments have a longer period of time to compound wealth. This is a wonderful way to easily accelerate your child’s retirement savings and recognize their hard work.
Lariat Wealth Management is not soliciting any action based on this material. It is for the informational purposes only. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested.