Contributing to Roth IRA for Children: The Benefits of Starting Early

Roth IRA

Although funding a Roth IRA might not spark much excitement, it is an investment strategy that could be worth considering.

If your child is old enough to work, then they are old enough to start contributing to a Roth IRA.

Children who have part-time jobs or summer jobs should make a habit out of contributing to Roth IRAs.

The reason Roth IRAs are so accessible for working teens is that the only requirement to contribute is having earned some income that year (not from investments or allowance).

Their earnings have to be legitimate but it doesn't matter your child's age or total earnings.

Benefits to an Early Start

While trying to figure out what to do with your retirement, it may seem strange to add your child's retirement plan to the list, but the earlier you start planning, the better.

Those under the age of 50 have a contribution limit of $5,000 maximum, so your child can hold on to some of the money they earned instead of investing all of it.

Here are three examples of the benefits of contributing to a Roth IRA for your child:

  • If your 15-year-old puts $1,000 into a Roth IRA each year for three years, the account would be worth $39,000 after 45 years at a 6% annual rate of return.
  • The same plan with a $1,500 annual contribution for three years would yield $58,000 in 45 years with a 6% rate of return.
  • If you invest $2,500 per year for three years, the account would be worth $97,500 after 45 years.

Although these sums might not support your child for 10 years, they provide a nice profit from small contributions.

Can Minors Open IRAs?

Depending on the state, children under a certain age (age 18 in most states) may not yet be able to set up an IRA on their own.

Many banks and brokerages will allow parents and legal guardians to set up custodial IRAs. They include popular firms such as:

  • Vanguard
  • Fidelity Investments
  • Charles Schwab
  • TD Ameritrade

With this type of IRA, the custodian (i.e., parent or legal guardian) will have control of the assets in this IRA until the child turns age 18 (or 21 in a few states). After that age, the child takes over those assets.

Roth IRA or Traditional IRA?

With a Roth IRA, your child will have access to all of his or her funds at any point, although before the age of 60, a withdrawal will not be tax-free.

It is better to leave the funds in the account until retirement age to get the most from the Roth IRA without owing any federal income tax.

The reason a Roth IRA is a better decision for your teen is because the withdrawals are not taxed like they are with traditional IRAs.

Traditional IRAs also carry a 10% penalty tax placed on any payouts before the age of 59 1/2 unless the money is used for IRS-approved reasons.

Traditional IRA Vs. Roth IRA

Traditional IRA Roth IRA
Contributions may be tax-deductible. Contributions are not tax-deductible.
Pay taxes upon withdrawal. Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth IRA for 5 years and you've reached age 59 1/2.
You must be under age 70 1/2 to contribute. You can contribute at any age.
Required minimum distributions (RMDs) are required starting at age 70 1/2. No RMDs required.

Which Investments to Use?

Like with any IRA, your child can invest the funds in a wide variety of investments.

At such an early age, child investors may stick to diversified mutual funds that are heavy on stocks.

Given their long investment time frames, children can afford to have their retirement funds take dips -- they have time for their portfolios to recover for recessions and economic downturns.

Solid options include index funds, index ETFs, and target-date funds.

Index funds and ETFs are baskets of stocks that track a certain index. They offer an easy way to diversify investments.

The simplest approach could be target-date retirement funds, which use a mix of index funds that match one's risk tolerance. The assets are allocated according to the investor's time frame.

In the case of a child investor, the appropriate target-date retirement fund would have a target year that is likely to be the furthest away. The fund will automatically tweak the asset allocation over time as the different asset percentages fluctuate.

Advantages of a Roth IRA

  • A Roth IRA allows for tax-free growth of your money.
  • Distributions are tax-free, assuming one meets specific requirements.
  • A Roth IRA account holder can choose from a number of mutual funds, along with using individual stocks, bonds, certificates of deposit, and other investments.
  • Traditional mutual funds tend to have lower fees than those available in 529 plans. This is due to the management and administration fees associated with 529 plans.
  • Roth IRA contributions can be withdrawn at any time without taxes or penalties.
  • Some parents choose to open a Roth IRA for their child with the expectation that any funds not used for college can remain in the account to give the child a head start on saving for retirement.
  • In the event that your child does not go to college, your invested funds can be shifted towards your retirement.

Disadvantages of a Roth IRA

  • Most fund companies require minimum initial payments of at least $2,500 a year.
  • Contributions must be included in base-year income, which can hinder financial aid benefits.
  • If you have more than a couple of children, the Roth IRA might not give you enough leeway to contribute towards your retirement and save enough for your kids. High fund requirements may reduce your ability to contribute for multiple children, leaving you with a decision between retirement and your children's college savings.
  • Funds that reside in a Roth IRA cannot be used as collateral for a loan, per current IRS rules, and therefore cannot be used for financial leveraging or for investment purposes.

Conclusion

No one wants to think of their kids growing old and weary, but starting a Roth IRA at a young age can help ensure your child will have a cushion of money for their spending needs.

If your child is not yet old enough to work, you can start teaching them about money management by setting up a savings account.

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