By Bill Bischoff
Last Update: 10:00 AM ET Oct 17, 2012
Making modest contributions during a childs teenage years can add up to a good by retirement. Its also tax smart.
Working at a tender age is an American tradition. Im sure lots of kids did just that over the summer, and some are still be doing it after school and over the weekends. What isnt so traditional is the notion of kids contributing to their own Roth IRAs. It should be a tradition, because its such a good idea. Heres the scoop.
Roth Contribution Basics
All thats required to make a Roth contribution is having some earned income for the year. Age is completely irrelevant. So if your child earns some cash from a summer job, or part-time work after school or whatever really the kid is entitled to make a Roth contribution. For the 2012 tax year, your child can contribute the lesser of: (1) earned income or (2) $5,000. These contribution limits apply equally to Roth IRAs and traditional IRAs, but the Roth alternative is the way kids should go in most cases for reasons Ill explain.
How Much Retirement-Age Money Are We Talking About?
By making Roth contributions for just a few years during his or her teenage years, your child can potentially accumulate a good sum of money by retirement age. (I know you dont want to think about your baby with gray hair, but it will happen.)
Realistically, most kids wont be willing to contribute the $5,000 maximum to a Roth IRA, even when they have enough earnings to do so. Try talking your teen into saving everything he or she makes instead of spending it at the mall and online. Good luck! Be satisfied if you can convince the kid to contribute at least a meaningful amount each year. Heres what could happen.
* Say your 15-year-old pays $1,000 into a Roth IRA each year for three years, starting this year. After 45 years (when your gray-haired kid is 60), the account would be worth over $25,000 assuming a 5% annual rate of return. If you assume a more-optimistic 8% return, the account would be worth just under $89,000.
* Say your child contributes $1,500 for each of the three years. With a 5% annual rate of return, the Roth account would be worth about $38,000 in 45 years. At 8%, it would be worth about $132,000.
* If your kid contributes $2,500 for each of the three years. With a 5% return, the Roth account would be worth about $64,000 in 45 years. At 8%, the number jumps to a whopping $222,000.
You get the idea. These are not trivial sums, even though the yearly contributions are modest.
Roth IRAs Are Usually Better for Kids than Traditional IRAs
For a kid, contributing to a Roth IRA is usually a much better idea than contributing to a traditional IRA for several reasons.
First, your child can later withdraw all or part of the Roth contributions without any federal income tax or penalty to pay for college or for any other reason. (Roth earnings generally cannot be withdrawn federal-income-tax-free before age 59.)
Even though Roth contributions can be withdrawn without any federal tax hit, the best strategy is to leave as much of the account balance as possible untouched until retirement age. That way, your child could accumulate the amounts mentioned earlier and never owe any federal income tax on those amounts. But if money must be withdrawn from a Roth IRA, it can be done tax-free up to the cumulative amount of contributions. Flexibility is a good thing.
In contrast, if your child contributes to a traditional deductible IRA, any subsequent withdrawals will be taxed. Even worse, payouts before age 59 will be hit with a 10% penalty tax, unless the money is used for certain IRS-approved reasons (one of which is to pay college costs, thankfully).
What about tax deductions for IRA contributions? Good question. Your child wont get any for Roth pay-ins, but the kid probably wont get any meaningful tax deduction for contributing to a traditional IRA either. Thats because an unmarried dependent childs standard deduction will shelter up to $5,950 of earned income (for 2012) from federal income tax. Any additional income will be taxed at low rates. So unless your child has enough income to owe a significant amount of tax (pretty unlikely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless to your child. Since thats the only advantage a traditional IRA has over a Roth IRA, the Roth option is almost always the best option.
The Last Word
Encouraging your working kid to make Roth IRA contributions is a great way to introduce the ideas of saving and investing for the future. Plus there are tax advantages. Its never too soon for your child to learn about taxes and how to legally minimize them. After all, its basically a game, and kids love games.