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Why Your Teenager Needs a Roth IRA Thumbnail

Why Your Teenager Needs a Roth IRA

Your teenager may not get rich mowing lawns or babysitting the neighborhood children, but contributing some of those weekend earnings to a Roth IRA can pave the road to a more secure financial future. Anyone with "earned income", regardless of age, is eligible to contribute. Though Roth IRA contributions are not tax deductible, most teens pay little or no taxes anyway, and Roth IRAs will allow their money to grow tax-free for decades.

Even if your child does not receive a W-2, just keep a record of the dates and hours worked and the amounts earned. Your child can contribute as much as $5500 each year to a Roth IRA as long as they don’t contribute more than their earned income for that year, and the source of the money does not matter. Often, parents or grandparents provide the cash for the contributions while the child’s actual earnings are saved for college. A Roth IRA can be opened at almost any financial institution. A good place for a child’s Roth is a discount brokerage or low-cost mutual fund company. Look for minimal annual fees, and consider a no-load, low-expense index fund as the investment vehicle. The deadline for contributing for the current calendar year is April 15 of the following year.

Below is a detailed example which illustrates how Roth contributions for children work, and how contributions made early in life can provide a significant boost to future retirement savings:

Thirteen-year-old Megan babysits a couple of times each month during 2015 and earns $25 each time. With her mother’s help, she records her earnings in a simple spreadsheet on her computer. By year’s end, she has earned $550. Though this money is deposited to her college savings account, her parents agree to provide the cash for Megan to open a Roth IRA for 2015. Each year until Megan graduates from high school, she contributes $550 to her Roth IRA. With her parents’ assistance, in early 2016 Megan opens a Roth IRA account online and chooses a diversified no-load equity index fund as the investment vehicle. Because she has no other earned income, Megan is not required to file a tax return and is therefore in the 0% tax bracket, so she does not need the deduction offered by a traditional IRA.

Assuming her Roth IRA earns 7% per year between ages 13 and 18, and she makes six annual contributions of $550, Megan’s account will grow to approximately $3,934 by the time she enters college at age 18. This is a small sum, but during the next 50 years of Megan’s college and working years, that amount will grow to an astounding $115,884 assuming the same 7% average annual return. Even with a more modest 4% annual return, Megan’s $3,300 in babysitting earnings would grow to $27,958 in 50 years. Had Megan waited until she completes graduate school at age 25 to begin contributing to a Roth IRA, she would need to contribute $468 every year for 43 years to end up with the same $115,884 at age 68.

Besides the obvious benefit of Megan's long time horizon over which the compounding of interest works its magic, Megan also learns at a young age the discipline of regularly saving for retirement. And saving at least 10% of one’s income for retirement is one of the fundamentals of fiscal fitness prescribed by all ACP planners.

Individual factors should always be considered before implementing a Roth IRA strategy, and consideration of changes in laws regarding Roth IRAs should be given.

Authored by fellow Alliance of Comprehensive Planner (ACP) member, Karin E. McKerahan, MBA, CFP.  Alliance of Comprehensive Planners