The Potential Benefits of Roth IRAs for Children
Most teenagers probably aren’t thinking about saving for retirement, buying a home, or even paying for college when they start their first jobs. Yet a first job can present an ideal opportunity to explain how a Roth IRA can become a valuable savings tool in the pursuit of future goals.
Rules of the Roth
Minors can contribute to a Roth IRA as long as they have earned income and a parent (or other adult) opens a custodial account in the child’s name. Contributions to a Roth IRA are made on an after-tax basis, which means they can be withdrawn at any time, for any reason, free of taxes and penalties. Earnings grow tax-free, although nonqualified withdrawals of earnings are generally taxed as ordinary income and may incur a 10% early-withdrawal penalty.
A withdrawal is considered qualified if the account is held for at least five years and the distribution is made after age 59½, as a result of the account owner’s disability or death, or to purchase a first home (up to a $10,000 lifetime limit). Penalty-free early withdrawals can also be used to pay for qualified higher-education expenses; however, regular income taxes will apply.
In 2022, the Roth IRA contribution limit for those under age 50 is the lesser of $6,000 or 100% of earned income. In other words, if a teenager earns $1,500 this year, his or her annual contribution limit would be $1,500. Other individuals may also contribute directly to a teen’s Roth IRA, but the total value of all contributions may not exceed the child’s annual earnings or $6,000 (in 2022), whichever is lower. (Note that contributions from others will count against the annual gift tax exclusion amount.)
Lessons for Life
When you open a Roth IRA for a minor, you’re giving more than just an investment account; you’re offering an opportunity to learn about important concepts that could provide a lifetime of financial benefits. For example, you can help explain the different types of investments, the power of compounding, and the benefits of tax-deferred investing. If you don’t feel comfortable explaining such topics, ask your financial professional for suggestions.
The young people in your life will thank you — sooner or later.
For questions about laws governing custodial Roth IRAs, consult your tax or legal professional. There is no assurance that working with a financial professional will improve investment results.