Many parents support their teenage children in the traditional sense, by providing an allowance, chipping in on car payments, and so on. What most do not realize is that there is an extremely powerful option to help their children start thinking about investing and planning for their financial future.
Once an individual has earned income from wages, he or she is eligible to save for retirement in an IRA or a Roth IRA. There are many rules and provisions surrounding these accounts, but the IRS does not stipulate where or who the contribution must to come from. Meaning, parents who are inclined to do so may make a contribution on their child’s behalf.
In particular, Roth IRAs represent a great opportunity to get your children interested in personal finance. Having assets in your children’s names provides them with a heightened sense of meaning surrounding the financial markets.
The Power of a Roth IRA
- Unlike a traditional IRA, Roth IRA contributions do not get an upfront tax deduction. After age 59.5, you are able to withdraw these assets from the account without incurring tax. All growth and income from your contribution accrues tax-free. In other words, with a Roth IRA you are electing to pay tax now rather than when you make an eventual distribution. For this reason, Roth IRAs are attractive for children given their often low tax rate.
- To quote Albert Einstein, “Compound interest is the eighth wonder of the world.” If, for example, one was to contribute $2,500 from a summer job from age 18-21 and earn 5% per year until age 65, this would translate to approximately $92,000 in Roth IRA assets. Saving the income from just 3-4 summers could potentially make a difference in the flexibility of one’s retirement.
- Under current law, there are no requirements to take required minimum distributions (RMDs) from a Roth IRA giving the assets an even longer time horizon to appreciate.
Practical Application
If funding a Roth IRA for your child is something you are interested in pursuing, here are a few things to keep in mind:
- Some financial institutions have age restrictions on accounts. If your child has not yet attained age 18, you may have to find a custodian who supports accounts for minors.
- The amount of your contribution cannot exceed the gross income reported on your child’s W-2 or $6,000, whichever is lower.
- Contributions must be made by the tax filing deadline of the year in which the income was earned and not necessarily December 31st.
- If you make the contribution on your child’s behalf these contributions are gifts and so gift-tax implications should be considered.
As with all financial decisions, opting to make a Roth IRA contribution on behalf of your child should be balanced with your competing goals.
