Roth IRAs for Kids
We all know that saving for retirement is important. The earlier one starts, the better the likelihood of having enough to last throughout retirement. For children, utilizing a Roth IRA a savings account can optimize their path to retirement as well as teaching them the importance of saving and investing. Below we will illustrate a few strategies to make this possible.
The Main Hurdle
In order to be able to fund a Roth IRA, the child must have earned income. For taxation purposes, there must be something on paper which says they have worked – whether it is from a W-2 or a 1099 tax form.
Another thing to note is the contribution limit. Just like everyone else, the limit is lesser of the of annual contribution limit - $6,000 as of 2019, or the total earned income for the year i.e. if the child only makes $1,000, then $1,000 is the maximum contribution limit.
Ways to Contribute
Assuming the child has earned income, there a few ways in which this Roth IRA can be funded.
- Using a portion of total earned income to contribute: Just as how we all set aside a portion of our pay into savings, this can foster a disciplined system of saving on a regular basis early on.
- Using your own income to fund your child’s contribution: This is a bit of a loophole but as parents, you can make contributions for your child’s Roth. It is recommended that you fully contribute to your retirement account first.
- Making matching contributions per a parent/child agreement: Like a 401(k) or qualified retirement plan structure, you can motivate your child to contribute from their own pocket with the promise that you will match that contribution from your end as well.
Besides the main benefits of instilling the behavior of saving early, the other benefits of utilizing this strategy are:
- Tax-Free Growth – Once withdrawals are made from this account during their retirement, there will be no taxes owed upon the distribution. This is assuming the tax laws don’t change in the distant future.
- Longer Time in the Market – Assuming investing begins into a Roth IRA during a child’s teenage years, after a 30 or 40 time period of being it the market, the chances of exponential growth are very high. For example, take a look at the graph below which demonstrates the effect of ten additional years in the market:
To provide some context, we assume an average of 6% annual growth.
The power of compounding over longer periods of time is clear.
- Other Qualified Withdrawals – Once a Roth has been opened and funded for at least five years, an individual is allowed to withdraw up to $10,000 for a first-home purchase, tax-free and penalty-free. In addition, funds from a Roth may be used to qualified education expenses. However, any earnings portion will be taxed. Despite having this option, one should look to other sources of income to fund home purchases and education expenses. Roth IRA’s should best be looked at as a source for retirement cash flows.
Everything considered, a Roth IRA should be an essential type of account in one’s array of retirement assets.