Ariel Skellley | digital vision | fake images
How would it feel to give your kids a head start on saving for retirement while helping them form healthy money habits?
The answer could be to open a Roth individual retirement account for them.
For starters, a Roth IRA is a special retirement account that allows participants to receive tax-free income in retirement. There are no age restrictions; therefore, a child can have a Roth IRA and get a huge head start on both their retirement savings and wealth-building goals.
It’s important to know that a child must have some earned income to contribute to a Roth IRA, but anyone can also contribute on behalf of an eligible child.
The IRS will consider earnings from a part-time job after school or summer work experience as eligible to invest in a Roth IRA. However, savvy business owners can also hire their children to help with filing, cleaning, or other tasks that allow them to help their children get this big retirement savings advantage.
When your child adds cash to his Roth IRA, he doesn’t get any tax breaks, which wouldn’t be valuable to him in any case, since tax rates on children are typically very low. However, the valuable tax benefits come at the rear.
Your child will be able to withdraw their contributions and earnings 100% tax free once they are over age 59½ (under current rules). Both the investment made and all the interest, dividends and growth of these assets escape the clutches of Uncle Sam and will accumulate a good amount of cash over time.
If your child needs access to the investment account sooner, they can withdraw their contributions tax-free and penalty-free for any purpose, if they’ve owned the account for at least five years.
Children have decades to grow their Roth IRA contributions, tax-free. The power of compounding works by exponentially increasing the value of the account. First, all earned profits will be added back to the principal amount, and then reinvested in the stock market to accelerate account growth.
A famous scholar, inventor, scientist, and diplomat also praised the power of compounding during his lifetime. Benjamin Franklin commented, “Money makes money. And money that makes money, makes money.” Franklin’s definition of compounding is spot on and why it’s powerful to save as much as you can at a young age.
While the layout may seem complicated, especially if you don’t have spreadsheet software, you can use a formula to do these calculations in your head. The Rule of 72 is a useful method of calculating how long it will take to double your cash.
To determine the amount of time to double your investment, divide 72 by the interest rate. For example, if your son invests in the S&P 500 index and earns a 10% return over time, he will double the value of his investment in the portfolio in 7.2 years (72 divided by 10).
Even Albert Einstein was impressed by this mathematics. There is an often told story that when asked what was mankind’s greatest invention, he said, “The most powerful force in the Universe is compound interest.” He referred to saving money and growing it as one of the greatest “miracles” known to man.
Opening a Roth IRA for your child is quite simple.
Schwab, Fidelity, E*Trade and many other companies offer custodial Roth IRAs for your children. As custodian of the account, you will control the IRA funds and make all investment decisions until your child reaches the age of majority.
In most states, the age of majority is 18, with others having higher ages of 19 or 21. Once your son or daughter reaches the age of majority as defined by their state, the Roth IRA is transferred to their name only.
A child of any age can save in a Roth IRA. However, the work your child does must be age-appropriate with “reasonable wages.” Knowing what earned income is is a snap with a job for a company that will issue your child a 1099 at the end of the year.
However, the line can become blurred when your child is working for you, babysitting, mowing lawns, or setting up their own business, like running a lemonade stand. Accountants agree that keeping good records and invoices for work performed is essential.
Parents can also help their children boost their Roth IRA savings by matching contributions.
For example, if their son earns $2,000 at his local ice cream parlor over the summer and saves half of it in his Roth IRA, the parents can add up to $1,000 more to the investment account. The only drawback is that your combined contribution must not exceed your child’s earned income for the year. Also, note that there is a maximum IRA contribution limit of $6,000 for 2022.
In addition to building a well-padded retirement fund, your child will start developing healthy financial behaviors from a young age. Studies show that the earlier kids learn about money and how it works, the better off they’ll be financially in the long run.
Unfortunately, you can’t trust your local school to teach you even the basics of good financial habits. Very few states require personal finance classes, and even fewer have qualified professionals teach the material.
Saving in a custodial Roth IRA with your child is the best way to ensure that you will be financially secure and develop a genuine regard for the value of your money, today and in the future.
The bottom line is that Roth IRAs are great for kids, because kids have decades to grow their contributions tax-free.
— By Stacy Francis, President and CEO of Francis Financial