With summer break just around the corner, many kids will be hitting the summer work scene. While its super cool to be earning wages as a lifeguard for the summer, it’s even cooler to use this opportunity to teach our kids some basic financial literacy by opening a Roth IRA for them. Wait, you might be thinking, you can really open a Roth IRA for a minor?! The answer is loosely, yes and what’s more, it could mean the difference between buying their own home down the road and renting, or working into retirement or being able to retire when they want to. Here are just a few of the many reasons to open one for your kid or grandkid:
- There are tax advantages for owning a Roth IRA. Namely, earnings grow federally tax-free and withdrawals (in most cases) are also tax-free.
- Minors have a long time to let that money grow. Take this example. You make a single contribution of $6,000 and let it grow for 60 years (assuming a 6 percent annual return*) and you end up with $200,000. If they waited until they were 35 to contribute the same amount to a Roth, they would need to save $46,000 to reach that same amount.
- Roth IRA funds can be used for retirement savings and as a down payment for closing costs on a first home (up to $10,000) tax and penalty free as long as the account has been open for more than five years. Funds can also be used in other circumstances but taxes and penalties may apply.
Now that we’ve seen some of the benefits of having a Roth IRA for a minor, here are the eligibility requirements for a minor:
- Must be under the age of 18. There is no minimum age, but see the next bullet.
- Must have employment compensation. Qualifying income can come from a job (think W-2 wages) and/or self-employment such as babysitting, mowing lawns, or shoveling snow.
The most important thing to consider is the compensation piece. Earning wages from a job on a W-2 is clearly the most straight forward way of satisfying the compensation requirement. Not all kids work in a job that provides them proof of income on a W-2 and that doesn’t disqualify them from having a Roth IRA. The IRS has set out guidelines for determining what is considered earned income in relation to being eligible to contribute to a Roth here. If income is coming from a non W-2 source, be sure to clearly document the hours worked and the compensation received and remember compensation has to be reasonable in terms of the scope of work (aka $2,000 for mowing the lawn is not reasonable). There are some instances where your minor may have to file a tax return and it is always recommended that you consult a tax professional to determine what rules may apply.
Lastly, remember that while your minor is under the age of majority, the adult maintains control of the account and must invest the account for the benefit of the minor. Once the minor reaches the age of majority, usually 18, the account becomes solely theirs and they can proceed to use the funds for whatever they desire. This is where using the Roth as a financial literacy tool is hopefully going to pay-off!
*This is a hypothetical example for illustration purpose only and does not represent an actual investment.
Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unless certain criteria are met, Roth IRA owners must be 59 ½ or older and have held the IRA for five years before tax-free withdrawals are permitted.