Landing that first job is a major milestone for most teens. Income means they can upgrade their phone, buy those ridiculously expensive sneakers they’ve been pining over or start piling up cash for their first car.
Or ... save for retirement?
As soon as kids start earning an income—whether it be from the local fast-food joint, shoveling snow or babysitting—they can start investing in a Roth IRA.
A Roth IRA is a retirement account that lets savers invest money that’s already been taxed. Unlike with 401(k)s and traditional IRAs, when you withdraw the money in retirement, the earnings aren’t taxed (assuming you follow the withdrawal requirements), making them great vehicles for young investors who are in lower tax brackets now than they will be in the future. And, should some sort of emergency arise, your child can withdraw the contributions made at any time without being penalized (just not the earnings).
If you can get your teen to think that far ahead and be disciplined enough to leave the money alone, the compound interest earned will work in overdrive for them. And if they’re rolling their eyes at the mere suggestion, let them play around with this compound interest calculator (or watch this video visualizing just how much compound interest adds up).
I calculated that investing $50 a month starting at age 16 (and assuming a seven percent rate of return) will turn into nearly $250,000 by retirement age. Obviously, as they get older, they’ll be increasing those contributions, but that’s a nice little start.
The Basics of Roth IRAs
There is no age minimum for a Roth IRA. You can open one for a child of any age, as long as they earn income.
A parent needs to open the account as the custodian. When the child turns 18, he will take ownership of it, although the logistics of how the account will transfer to the child may vary depending on the firm.
A Roth IRA is more flexible than other retirement accounts because the contributions can be withdrawn at any time for any reason (however, the investment earnings may be hit with income taxes and early distribution taxes).
There are contribution limits. They can contribute up to the amount they have earned that year or up to the Roth IRA contribution limit, which is $6,000 in 2019, whichever is less.
Like all retirement accounts, you/your child needs to invest the money. Look for low-cost ETFs and mutual funds. This is a great opportunity to sit down with your kid and talk through risk tolerance, asset allocation, how the stock market works, etc.
How to Get Started
Cheryl Krueger, a certified financial planner and founder of Growing Fortunes Financial Planners, opened her son’s Roth IRA with Charles Schwab, but she says any low-cost brokerage firm that offers index funds for low fees and no transaction fees will do. There are other online options, such as Betterment, that might be more technologically appealing to teenagers, she says, but “since I didn’t want my son constantly checking on the balance of his account, I opted for a more traditional discount broker.”
Krueger also recommends that you make sure you talk “fees” before you open the account: “If you’re not experienced with independent IRA/Roth IRA accounts, make sure you ask about fees for both the investments themselves and for holding the account. Some institutions charge an annual fee for small accounts.” Vanguard and Fidelity are great, low-cost options.
For more on how and where to open a Roth IRA, here’s a good explainer.
What to Know About Taxes
Krueger says parents will need to file a Form 8606 to show the Roth IRA contribution and that it is less than the child’s earnings from W-2 income. “The brokerage firm will not ask for income verification, that’s up to the contributor no matter what the age of the contributor, so it’s the responsibility of the taxpayer to make sure they don’t exceed the limits,” Krueger says.
Here’s a little more on that from personal finance writer Arielle O’Shea at Nerdwallet:
Earned income is defined by the IRS as taxable income and wages—money earned from a W-2 job, or from self-employment gigs like baby-sitting or dog walking. (If you want to contribute to your child’s Roth IRA or match your child’s contributions, that’s fine as long as she has at least as much earned income as the total contribution amount.)
For more on how to properly file taxes when your child has a Roth IRA, you can work directly with a tax professional.