Give your kids a head start on their retirement

Let’s talk about retirement security for our children. This may seem like a novel notion, and it’s probably one that you haven’t spent much time on. But it’s never too early to start building a retirement nest egg. And isn’t providing your kids with a leg up on their retirement years one of the most precious gifts you can give them?

In that vein, Roth IRAs can be a great vehicle for starting your kids off on the right path—indeed, not only for retiring but more broadly for succeeding financially and appreciating the power of saving and investing.

Why a Roth

With a Roth, taxes are paid on contributions, not on withdrawals, provided that certain requirements are met. And if you set up a Roth for a child, any taxes on contributions are based on his or her income, not yours. Since most kids pay little or nothing in taxes, the Roth benefit of tax-free growth is magnified. (If taxes are due on contributions, it’s better if they’re taken from another source, not the Roth IRA money, to maximize growth.)

If you open a Roth for your child, the current maximum annual contribution is $6,000 for those under 50, just as for a tradit ional IRA. Equally important, contributions are limited to earned income—whether the contributions are made by the child, by you, by anyone else, or any combination thereof.¹

Meanwhile, Roth IRA contributions can be taken out at any time with no taxes or penalties. The earnings in the account can also be taken out tax- and penalty-free at age 59½—or sooner for expense carve-outs, including certain educational, home-buying, and medical outlays.² And while income limits still apply, they’re based on the kid’s income, not yours: Rare is the child who has annual income in excess of the Roth cut-offs.

Thirty-Fold Growth?

If a Roth IRA were set up for a 15-year-old who held onto it for 50 years until retirement, he or she would enjoy tax-free compounding for a half-century. Assume that such an account were established with $5,000 and never again enhanced by further contributions—as unlikely as that is. The account value would grow to more than $50,000 at a 7% annual return, which is not unreasonable for a stock-heavy balance. All of that money could be withdrawn without paying a dollar in taxes and with no required minimum distributions.

What’s the Catch?

There really isn’t a catch, but parents need to think about the following:

• Again, only the child’s earned income can be contributed— not investment income, gifts, or allowances, and probably not money you give him or her for doing household chores. But working in a store or a company; baby-sitting, dog-walking, lawn-tending, and such; and taking a position in a parent’s business for reasonable pay are all fair game.³ While a W-2 is ideal, it is not required, but you need to make sure that accurate records are kept?
• No matter how many people choose to contribute, the total contributions in any given year by all parties, including the child, cannot exceed the child’s earned income
• The account will be managed by a custodian—typically parents—until the child reaches his or her majority: age 18 in almost all states. At that point, the account moves wholly to the child. If you’re unsure about your child’s maturity level, it may be best to choose a savings option that’s more in your control

1. Any contributions made to the child’s IRA by parents or other parties count against their limits for tax-free gifts.

2. We’re assuming throughout this article that the current tax laws on Roth IRAs remain as they are.

3. The child may need to pay a federal self-employment tax, currently at 15.3%, on his or her earnings (regardless of whether he or she is the beneficial owner of an IRA).