Roth IRAs for the Kiddos

May 5, 2022  | By David Lowe

How your teenager (or even younger child) can benefit from a Roth IRA

You have a high-achieving teenager who balances high school studies, chores and extracurricular activities with part-time work. Or maybe your college student took a job to help pay for tuition. At any rate, congratulations! Your young adult is developing valuable workforce skills, time management abilities, independence and responsibility.

Motivating your child to gain work experience is a crucial first step, but how can you help even more? Consider opening a Roth IRA, which your child will fund regularly from his or her earnings.

Much as it’s never too soon to start saving for college, it’s never too early to mentor young adults in the discipline of long-term investing. Even before your child secures a rewarding full-time job with company retirement benefits, a Roth IRA account is a great way to start.

Who May Contribute

There are no age limits on Roth IRAs. Anyone who reports earned income – but not more than the IRS annual limit – may contribute. No W-2? No problem! Self-employment, including longtime youth staples such as income from yard work, counts, too.

A legal adult may open his or her own account and start investing. For a minor, a parent may open a custodial IRA to hold the funds until the child turns 18 – or whatever the age of majority is in the family’s specific state.

Why a Roth IRA versus some other type of investment account? Because discipline and delayed gratification can mean big income tax savings later in life, when enjoying financial independence.

Tax Savings

Roth IRAs provide tax-free growth, along with tax-free withdrawals of earnings once the account holder reaches age 59.5. (An account holder can withdraw contributions at any time without penalty and can withdraw earnings under a few other specific circumstances, but often, the most beneficial plan is for a young investor to let the Roth dollars grow untouched for decades. As with other retirement accounts, harnessing the power of compounding growth is a key method of building long-term wealth.)

Because Roth IRAs create a tax-free income stream for retirement, workers can benefit significantly by funding them when they are young. A teenager who works part-time, for example, likely will be in one of the lowest income tax brackets. For 2022, income up to $10,275 is taxed at 10 percent. Income from $10,275-$41,775 is taxed at 12 percent. With those rates, decreasing taxable income through pre-tax deductions probably is not a big priority. On the other hand, your child’s post-tax Roth IRA contributions today are like a big gift (of tax-free income) to his or her future self!

Fast forward a few decades. Your child has harnessed all the potential you saw way back when he or she was competing for drum major, filling your weekend calendars with basketball tournaments across the state, or honing a case for the debate team. Now, he or she may be selling a lucrative business, advancing in the corporate executive ranks or inventing the next new world-changing technology. At any rate, he or she likely has moved into a much steeper tax bracket.

With high income likely to continue through the late career years, or even in retirement, a Roth IRA account that has been growing since youth provides a lot of tax flexibility. That is especially true if Congress raises income tax rates, which now are lower than they have been for much of the past century. (Think taxes are high now? The top marginal rate was 60 percent or more from the early 1930s to the early 1980s.) Because your child likely will face higher tax rates in the future than now, it helps to have an ample source of tax-free funds to draw from in retirement, if desired.

Contribution limits

The sooner your child starts contributing to a Roth IRA, the more the money can grow. For 2022, an income earner younger than 50 may contribute a maximum of $6,000 to a Roth IRA, as long as the person earned at least $6,000 for the year. If income is less than $6,000, the actual amount earned is the maximum the person may contribute to a Roth IRA.

The ability to contribute to a Roth IRA phases out for single tax filers with Modified Adjusted Gross Income of $129,000-$144,000. Those who make more than $144,000 are not eligible to contribute to a Roth IRA. That probably won’t affect your young income earner, and if it does, it’s a good problem to have! The point is, a Roth IRA can be a great option for the vast majority of young people who are just starting to earn income.

Consider automatic contributions

As with investors of any age, automatic contributions sure can make things easier. Custodians such as Schwab and TD Ameritrade accept even relatively small monthly contributions, which can allow young workers to start investing in manageable amounts. If you set up a custodial account or help a young adult child open his or her own account, use automatic drafting to your advantage. It’s a great way to simplify busy schedules, keep from accidentally missing a contribution and take advantage of dollar cost averaging – a strategy that smooths out costs over a long time and helps investors “buy low.”

Beyond dollars and cents

By helping your child start contributing to a Roth IRA, you can foster long-term investing habits that will last a lifetime. There’s more to it than just the money, though. Helping teenagers, or even younger children, invest in a Roth shows them that you respect their hard work, that you are confident in their decision-making abilities and that you believe their best years are ahead of them. It shows them that you are giving them a healthy challenge – and that you believe they will rise to the challenge.

I vividly remember when my grandfather started a Roth IRA for me. I was 18, visiting him on the west side of Houston for Thanksgiving, and had earned some money the previous two summers by working in my parents’ small business. My granddad drove me to his financial advisor’s office, which was neatly decorated with verdant plants and warm artwork. As the advisor explained the main characteristics of Roth IRAs, it hit me. I was an adult! A polished professional was speaking to me with respect in understandable terms. My granddad – a perpetually active man who volunteered regularly, constantly fixed things around the house and scoured the Wall Street Journal for investment wisdom – had taken time out of his day to help a teenager learn a new tool for managing money. To put it simply, he treated me like a man. He had faith in me.

Intergenerational connections and family conversations may be the most important gains you realize by helping your children start a Roth IRA. (Or, for that matter, by engaging with them in any other deep conversation about money.) When outlining the foundations of long-term investing, you can find opportunities to talk about how to earn money in an ethical, fulfilling way. You can learn about your children’s work goals, their other ambitions and their big hopes for the future. You can discuss how money is not an end, but a means – a way of funding what is truly meaningful and lasting to your family.

A few simple steps not only can set up young people for future tax savings, but also can point them toward a life well-lived.