Roth IRAs give children a jumpstart on retirement saving

Roth IRAs give children a jumpstart on retirement saving
Eileen St. Pierre, The Everyday Financial Planner

Blog_award_Lemonade_StandMany parents ask me if they can open up retirement accounts for their kids. The answer is yes, but only if their child has earned taxable income. Investment income like interest on savings bonds does not count. Parents can open custodial or guardian IRAs for their minor children. It can be a great way to teach your child about saving and investing.

Most retirement plan providers offer custodial IRAs.

Investment companies will require parents or guardians to serve as the account custodian until minors reach the age of majority in their state of residence. The same IRA contribution limits apply to minors.

  • Children can contribute up to $5,500 (2015 and 2016) or the amount of their earned income, whichever is less.
  • If your child earned $3,000 working as a lifeguard over the summer, the most he can contribute to an IRA is $3,000. You cannot kick in another $2,500.

Make sure their work is documented.

If your daughter works in the family business, make sure you provide proof of wages if no W-2 is received. If your son mows lawns, it helps if he mows lawns for your neighbors, not just you.

Choose a Roth IRA.

Most children will not earn enough money in a year to benefit from the tax deduction that a Traditional IRA allows. They are in a very low tax bracket – probably the lowest they will be in their entire lives. By contributing to a Roth IRA, they pay the income tax now but the money will be tax-free in retirement.

The power of compounding is HUGE!

Let’s say a 16-year old contributes $5,500 into a Roth IRA. She makes no other contributions. The money is invested in a broad stock market index fund that averages 8% a year. She leaves the money in there for 50 years. Guess how much she will have at age 66? Almost $258,000!

  • Suppose after this initial investment of $5,500, she only contributes $1,000 a year for the rest of her working life. After 50 years, she would have almost $832,000.
  • To be a millionaire in 50 years, she would only have to make annual contributions of $1,300 going forward.
  • Remember – this money will be tax-free in retirement.

So the next time your children complain that saving money is no fun, show them these numbers. Who doesn’t want to be a millionaire?