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 traditional 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.
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 All of that money could be withdrawn without paying a dollar in taxes and with no required minimum distributions.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.
Easy to Set Up
If you’re interested in establishing a Roth IRA for your child, we can help: We’ll discuss an investment schedule, asset allocation, and annual contribution level that’s appropriate for you and your child. And we can set up the custodial account that will be necessary. We also encourage you to speak with your tax advisor.
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).