As a parent, you want to help guide your children towards a path of success. Teaching them about compound interest and the importance of investing early in life will help guide them down the right track to reach their financial goals. With many different investment options available (Roth IRAs, bonds, equities, 401ks, etc.), choosing the right one for their phase of life can be challenging. For the sake of this Q&A, we are going to focus on children who have begun to earn reportable income. This income may be through jobs like babysitting or yard work, but the income must be reported to the IRS.
Roth IRAs
Roth IRAs are a popular investment option for young investors beginning to earn income. This is because their young age will allow for decades of tax-free growth. In addition, family members can open custodial Roth IRAs for minors participating in the work force. A child that is considered a minor (under 18-21 depending on the state) is restricted from opening their own account.
Keep in mind, Roth IRAs can only be opened when the child has reportable earned income (income reported to the IRS). In addition, total yearly contributions must not exceed the lesser of their yearly earned income or $6,000 (as of 2022).
If a custodial Roth IRA is selected, the child will gain control of the account at the age of majority. This is typically between 18 to 21 years old. If you do not wish for this to occur, your Advisor can assist you in selecting an appropriate option.
What are the benefits of a Roth IRA?
More time equals more growth
The more time there is for money to grow, the more powerful the impact of compound interest. For example, a 16-year-old may have 50 years for their investments to grow before retirement. If we assume a 6% rate of return, a small contribution of $100 per month over 50 years ($1,200 yearly or $60,000 total) would grow to almost $400,000.
Tax-free growth
As there is no tax break for putting money into the account, qualified distributions are not taxed. Your child’s income is likely much lower now than it will be in the future. If they were to give up the tax break now, they will be able to access the money tax-free in retirement when their tax rates will likely be much higher.
Contributions can be withdrawn at any time
Unlike other retirement accounts, contributions made to a Roth IRA can be withdrawn before age 59 ½. With that said, a 10% penalty and/or taxes may be applied to any interest or earnings withdrawn for non-qualified distributions. If the Roth IRA has been held for over 5 years, qualified distributions include being over age 59 ½, first-time home purchases, or having a disability. Although contributions may be withdrawn, the longer they stay in the account, the more opportunity they will have to grow!
Conclusion
Roth IRAs are a popular investment vehicle in general, but the benefits are magnified the earlier you start contributing. If you have questions about Roth IRAs and other investment options for your child, reach out to your Advisor.
Updated: June 24, 2024
Written: May 15, 2022