How to jump start your child’s retirement
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Do you have a high school or college-age child? Knowing what you know now, I bet you would like to give them a head start on retirement savings, right? The good news is, if your child works, you might be able to do just that.
Is My Child Eligible?
If your high school or college student has a summer job or other part-time employment, they are eligible to contribute to an IRA. For 2024, that amount is $7,000 or the total earned income, whichever is less. So, if your son earned $1,500 last summer, he could contribute up to $1,500 to his IRA. If your daughter earned $10,000, the maximum she can contribute is $7,000.
One important caveat: Earned income does not include dividends, interest, or capital gains from an investment portfolio. Earned income constitutes wages paid by an employer who withheld taxes and reported the earnings to the Internal Revenue Service. Suppose your child’s income comes from babysitting, mowing lawns, or doing odd jobs around the neighborhood. In that case, they must maintain careful records to qualify as “self-employed” and be eligible to make a contribution.
A Roth Versus a Traditional IRA
If your child is eligible, you must select the type of IRA to invest in. Traditional IRAs (which provide for a tax deduction in the year of the contribution) are generally not the best choice for students. Since most students pay little or no taxes, the tax deduction they’d receive for a contribution to a traditional IRA is not that beneficial. Plus, any eventual withdrawals from a Traditional IRA are taxed as income. While that may not be a big consideration now, it could be important to your child later in life.
As a tax-free retirement savings vehicle, a Roth IRA offers the greatest opportunity for growth. While Roth IRA contributions aren’t tax deductible, the earnings and future withdrawals are not taxed. This can be particularly advantageous when your child is in a higher tax bracket later in life.
Establishing a Roth IRA
As a minor, your child will need an adult to open a custodial Roth IRA. The “named custodian” doesn’t have to be the main contributor to the account. For example, a grandparent might wish to provide funds but may not want the custodian’s responsibilities. Once the child attains adulthood, they will take control of the account.
While intended for long-term savings, a benefit of the Roth IRA is that the contributions can be withdrawn at any time without tax or penalty, regardless of the account owner’s age. Earnings, however, cannot be withdrawn until the Roth IRA has been established for five years and the owner is over 59 ½ years old. Investment earnings withdrawn before the owner is age 59 ½ will be taxed and may be subject to a 10 percent penalty. No penalty is assessed if the withdrawals are used for education or a first-time home purchase, although the earnings are still taxed.
But Would My Child Contribute?
Your child might be saving for college or accumulating cash for future acquisitions such as a house or car. Or their job may simply provide spending money for fun. Saving for retirement is probably the last thing on their mind! It might require a conversation to convince them of the benefits of funding a Roth IRA. Perhaps this will help:
Even relatively minor contributions can add up, thanks to the magic of compounding. For example, if you make an annual $2,000 contribution from the time your child is age 15 to the time they are 22, and the account earns an 8 percent return every year, it would be worth nearly $500,000 when your child turns 62. Even a relatively modest $500-per-year contribution would grow to nearly $125,000. And remember, this is tax-free money your child can use during retirement or to pass along to their heirs.
If they still need a nudge after that, you could offer to match any amount they are willing to add to the account. That gives them some skin in the game while reducing their financial commitment.
Contributions can come from any source: your child, parents, grandparents, or anyone else can contribute to the Roth IRA (up to the allowable limit). No gift tax will be due as long as the total calendar-year value of all gifts from any one person is $18,000 or less. Therefore, even if your child cannot contribute to the Roth IRA out of their own money, you can still help them save by contributing on their behalf, so long as they have sufficient earned income.
Summary
This Roth IRA account alone is unlikely to meet all your child’s financial needs. But getting one started early does provide a head start for a financially secure future. This is a long-term investment. Your child will probably not fully appreciate your generosity today, but as they grow, so will the account and (hopefully) their gratitude!
David Crossman, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email David at dcrossman@bedelfinancial.com.