If you have a teenage child who works, consider encouraging the child to use some of the earnings for Roth IRA contributions. All that’s required to make a Roth IRA contribution is having some earned income for the year. Age is completely irrelevant. Specifically, for both the 2010 and 2011 tax years, your child can contribute the lesser of: (1) earned income or (2) $5,000.
Modest Contributions at an Early Age Can Amount to Big Bucks by Retirement Age
By making Roth IRA contributions for just a few years, your child can potentially accumulate quite a bit of money by retirement age. Realistically, however, most kids won’t be willing to contribute the $5,000 annual maximum even when they have enough earnings to do so. Be satisfied if you can convince your child to contribute at least a meaningful amount each year. Here’s what can happen. If your 15-year-old contributes $1,000 to a Roth IRA each year for four years starting now, in 45 years when your “child” is 60 years old, the Roth IRA would be worth about $33,000 if it earns a 5% annual return or $114,000 if it earns an 8% return.
If your child contributes $1,500 for each of the four years, after 45 years the Roth IRA would be worth about $50,000 if it earns 5% or about $171,000 if it earns 8%. If the child contributes $2,500 for each of the four years, after 45 years the Roth IRA would be worth about $85,000 if it earns 5% or a whopping $285,000 if it earns 8%. You get the idea. With relatively modest annual contributions for just a few years, Roth IRAs can be worth eye-popping amounts by the time your “kid” approaches retirement age.
Why the Roth IRA Is Usually the Better IRA Option for Kids
For a child, contributing to a Roth IRA is usually a much better idea than contributing to a traditional IRA for several reasons. The child can withdraw all or part of the annual Roth contributions-without any federal income tax or penalty-to pay for college or for any other reason. (However, Roth earnings generally cannot be withdrawn tax-free before age 59 1/2.) In contrast, if your child makes deductible contributions to a traditional IRA, any subsequent withdrawals must be reported as income on your child’s tax returns.
Advice: Even though a child can withdraw Roth IRA contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the account balance as possible untouched until retirement age in order to accumulate a larger federal-income-tax-free sum.
What about tax deductions for traditional IRA contributions? Isn’t that an advantage compared to Roth IRAs? Good questions. There are no write-offs for Roth IRA contributions, but your child probably won’t get any meaningful write-offs from contributing to a traditional IRA either. That’s because an unmarried dependent child’s standard deduction will automatically shelter up to $5,700 of earned income (for 2010) from federal income tax. Any additional income will probably be taxed at very low rates. Unless your child has enough taxable income to owe a significant amount of tax (not very likely), the advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that’s the only advantage a traditional IRA has over a Roth IRA, the Roth option almost always comes out on top for kids.
Again, these are just a few suggestions to get you thinking. Please call us at (212)387-7880 if you’d like to know more about them or want to discuss other ideas.