This past summer, my business partner's son turned 21. In addition to a beer brewing system, she also gave him a gift with an eye on his future- a Roth Ira. It got me to thinking about what a great idea that was and how other parents and grandparents can help their children and grandchildren get a head start on their retirement savings.
First, let's discuss the basics of the Roth IRA. Introduced in 1997, this Individual Retirement Account uses after-tax dollars (as opposed to pre-tax dollars that fund Traditional IRAs). Earnings accumulate tax-deferred and all withdrawals after age 59 ½ are 100% tax-free. Roths are more flexible than their Traditional counterparts in that contributions may be withdrawn without tax or penalty, thus opening the possibility of using funds for college or a house purchase. Ideally, of course, the Roth should be utilized for long-term retirement savings. Anyone with earned income may contribute to a Roth IRA. The maximum annual contribution is currently $5,000 unless you are over 50 years old, in which case you may put in up to $6,000. There are income limits with the Roth- in other words, if you make too much money, you're not eligible to contribute. For the sake of this article, I'll assume that your teenaged son or daughter is well within these limits, unless he or she is on the Mark Zuckerberg career track.
If you'd like to consider gifting money for a Roth, first you need to make sure your recipient has earned income. It doesn't matter how old he is, but there must be earned income whether it be from babysitting, a part-time job, etc. Interest earned on savings or investment accounts doesn't count, nor does money given to them. Now, there is nothing that says the Roth IRA must be funded with the actual dollars they earn. Let's face it- it's probably not realistic to think that your child will put all of their hard-earned money into an investment account that they won't use for 45 or 50 years. So, if your daughter earns $2,000 working part-time at Dunkin Donuts, she doesn't actually have to use that money for the Roth. That $2,000 simply indicates the maximum that could be contributed for that year. You may give her the $2,000 to put in to her Roth. Many people will wait until late January when their child or grandchild gets their W-2 and then make a contribution for exactly that amount. The deadline for making IRA contributions is the tax-filing deadline, typically April 15th of the following year.
An important incentive for deciding to start a Roth IRA for a teenager or young adult is quite simply the magic of compounding returns. We often tell our clients that "time in the market is more important than timing the market." Putting even small amounts of money to work for upwards of fifty years can have dramatic effects. Consider a 15 year-old who invests $1,500 a year for 3 years and averages 5% annual returns over 45 years. At age 60, that $4,500 would be about $38,000. At 8%, the effect is even more amazing- it would be worth about $132,000.
Another reason for putting money into a Roth IRA versus other savings or investment plans is that retirement plans don't affect college financial aid. If a college-bound student has money in her own name in other types of accounts, they may alter financial aid calculations.
And finally, does anyone have any doubt that tax rates are going up in the future? Whether that happens in January or years from now, it's a pretty safe bet. If your teenager can pay taxes on his (low) income today when rates are historically low and lock in tax-free gains for the rest of his life, why not do it? I can envision a future generation of 60-somethings getting ready to retire and being pretty pleased with their parents' or grandparents' decision to start a Roth IRA for them back in 2012. Even if you're not in a position to be giving your child money to fund their Roth, encourage them to add a little money from each paycheck they earn. It's okay to start small, and it instills in them the value of saving for the future even now while they're still worried about homework and the prom.
First, let's discuss the basics of the Roth IRA. Introduced in 1997, this Individual Retirement Account uses after-tax dollars (as opposed to pre-tax dollars that fund Traditional IRAs). Earnings accumulate tax-deferred and all withdrawals after age 59 ½ are 100% tax-free. Roths are more flexible than their Traditional counterparts in that contributions may be withdrawn without tax or penalty, thus opening the possibility of using funds for college or a house purchase. Ideally, of course, the Roth should be utilized for long-term retirement savings. Anyone with earned income may contribute to a Roth IRA. The maximum annual contribution is currently $5,000 unless you are over 50 years old, in which case you may put in up to $6,000. There are income limits with the Roth- in other words, if you make too much money, you're not eligible to contribute. For the sake of this article, I'll assume that your teenaged son or daughter is well within these limits, unless he or she is on the Mark Zuckerberg career track.
If you'd like to consider gifting money for a Roth, first you need to make sure your recipient has earned income. It doesn't matter how old he is, but there must be earned income whether it be from babysitting, a part-time job, etc. Interest earned on savings or investment accounts doesn't count, nor does money given to them. Now, there is nothing that says the Roth IRA must be funded with the actual dollars they earn. Let's face it- it's probably not realistic to think that your child will put all of their hard-earned money into an investment account that they won't use for 45 or 50 years. So, if your daughter earns $2,000 working part-time at Dunkin Donuts, she doesn't actually have to use that money for the Roth. That $2,000 simply indicates the maximum that could be contributed for that year. You may give her the $2,000 to put in to her Roth. Many people will wait until late January when their child or grandchild gets their W-2 and then make a contribution for exactly that amount. The deadline for making IRA contributions is the tax-filing deadline, typically April 15th of the following year.
An important incentive for deciding to start a Roth IRA for a teenager or young adult is quite simply the magic of compounding returns. We often tell our clients that "time in the market is more important than timing the market." Putting even small amounts of money to work for upwards of fifty years can have dramatic effects. Consider a 15 year-old who invests $1,500 a year for 3 years and averages 5% annual returns over 45 years. At age 60, that $4,500 would be about $38,000. At 8%, the effect is even more amazing- it would be worth about $132,000.
Another reason for putting money into a Roth IRA versus other savings or investment plans is that retirement plans don't affect college financial aid. If a college-bound student has money in her own name in other types of accounts, they may alter financial aid calculations.
And finally, does anyone have any doubt that tax rates are going up in the future? Whether that happens in January or years from now, it's a pretty safe bet. If your teenager can pay taxes on his (low) income today when rates are historically low and lock in tax-free gains for the rest of his life, why not do it? I can envision a future generation of 60-somethings getting ready to retire and being pretty pleased with their parents' or grandparents' decision to start a Roth IRA for them back in 2012. Even if you're not in a position to be giving your child money to fund their Roth, encourage them to add a little money from each paycheck they earn. It's okay to start small, and it instills in them the value of saving for the future even now while they're still worried about homework and the prom.
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