Author: Barbara Rizvi, Director of Financial Planning
The first job is a rite of passage for many teenagers, and understandably few are thinking about funding their retirement when they receive their first paycheck. However, with a little coaching on the value of Roth IRAs, parents can help their industrious teenagers create a golden nest egg.
With a Roth IRA you contribute after-tax dollars but the investment grows and is distributed tax free after age 59 ½ (as long as you’ve had the account more than five years), regardless of your tax bracket. Total contributions to a Roth IRA are limited to the lower of the IRS contribution limit ($6,000 in 2020) or the amount of income your child earns through self-employment (babysitting, mowing lawns, pet sitting) or a traditional W-2 job. For teenagers, whose earning level often exempts them from taxes, this can result in a 100 percent tax free investment!
The power of compounding interest is also greatest for a teenager as they have the longest period of time to reap the benefits. For example, if your 15-year-old son or daughter contributes just $2,000 to a Roth IRA and it grows at a modest five percent rate of return until they turn 65, your teen’s $2,000 will have turned into $24,000. If they are eligible to contribute up the 2020 maximum of $6,000, this will have grown to nearly $73,000.
While the financial benefits of investing in a Roth IRA are apparent, there are many lessons that can be learned by opening a Roth IRA as a teenager.
For one thing, it’s a great way for parents to educate youth on the value of saving and the basics of investing. Opening a Roth IRA encourages parents to sit down with teens and discuss how much of their earnings they should spend versus save, the concept of compounding growth, the different types of investments and the risks and rewards associated with investing. Through this process, you are instilling lifelong lessons and encouraging a healthy attitude toward saving and investing. Dinner conversation can be very exciting as your teen watches the value of their investment go up and very educational during times when the value goes down!
Contributions don’t necessarily need to come from the teen. If you are wanting and able to do so, parents can also utilize Roth IRAs to incentivize youngsters with a competitive edge to work harder or save more. As long as your child is making money, you or any adult can contribute to your child’s Roth IRA on their behalf. Depending on what type of behavior you are trying to encourage, you can match your child’s contribution or their earnings with a gift to their Roth IRA. Remember, total contributions (regardless of the source) cannot exceed the account contribution limit set by the IRS. Also, make sure you have provided adequately for your own retirement before making investments for your child.
While a Roth IRA is intended to be a retirement planning tool, it has flexibility that makes it an attractive tool for younger investors should life throw them a curve ball.
Because Roth IRA contributions are made with after-tax dollars, contributions to a Roth IRA can be withdrawn anytime without penalty, regardless of your age or how long you have had the account. It’s important to note that this only applies to the contributions, rules apply for premature distributions of the investment earnings.
Investment earnings taken before you are 59 ½ and before at least five years have passed since the first contribution was made to your Roth IRA are generally subject to a 10 percent penalty and the payment of income taxes.
However, below are some exceptions to the investment earnings rule that are particularly applicable to young Roth IRA owners.
Roth IRAs can be opened as soon as your child starts earning income, regardless of their age, as long as an adult acts as a custodian for the account and your child is reporting that income to the IRS.
Once your child reaches the age of majority in your state (typically 18 or 19), he or she will assume ownership and be able to control the account as they choose.
If you’re interested in opening a Roth IRA for your child, talk to your financial advisor or connect with one of FNBO’s financial advisors to get started.
About the Author
Barbara is a Certified Financial Planner (CFP®) and Director of Financial Planning with the Private Client Advisory and Financial Planning teams at First National Bank Wealth Management. She specializes in providing comprehensive and personalized financial planning that incorporates investment, retirement, tax, protection and estate planning strategies.