Do you want to give your child or grandchild a financial head start? A Roth IRA may be an option to consider. Funds contributed to a Roth-IRA are after-tax dollars. However, the primary benefit is that qualified withdrawals are tax-free, meaning the growth in the account is tax-free. Potential decades of earnings growth for a young person can make a Roth-IRA very appealing.
If your teen has earned income, you may be able to set up a Roth IRA for them. For example, if your 16-year-old has income from a summer or part-time job, you can set up an account for them and contribute up to $6,000. The maximum annual Roth IRA contribution is $6,000; however, the amount contributed cannot exceed the teen’s income. The money you contribute to the Roth IRA can count as a gift within your $16,000 annual gift tax exclusion ($32,000 for a married couple). Figures reflect IRA limits in 2022.
Keep in mind, if earnings are withdrawn from a Roth IRA before age 59½, a 10% federal tax penalty may apply. This penalty reinforces the primary purpose of a Roth IRA: a long-term investment for retirement. While you can always withdraw the money contributed with no tax or penalty*, an exception to note is that up to $10,000 of investment earnings can be taken out of a Roth IRA at any time if the money is used to buy a first home. A portion of the Roth IRA assets may also be used to pay college expenses for the Roth IRA owner (your teen) or, should your teen become a parent someday, their spouse or child.
Magic of Compounding
Setting up a Roth IRA for a teenager is a great way to introduce them to basic financial concepts, such as compound interest. Giving your teen a hands-on learning experience may help them understand the value of saving for the future. You may also be facilitating the development of your children’s or grandchildren’s financial habits.
Setting up a Roth IRA for a minor is often referred to as a custodial IRA. Until the child is able to take it over, you act as the custodian of the account. Individual state laws determine when the minor child is able to take over management of the Roth IRA. A tax professional can provide guidance that may help ensure that you and your minor child are following all federal and state tax regulations.
All things considered, this strategy may be a win with long-term benefits for you and your teen.