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A Simple Guide to Roth IRAs For Kids and Teens

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Last Updated on June 5, 2023 by Carolyn

A Simple Guide To Roth IRAs for Kids and Teens

What is a Roth IRA and Why Your Kid Should Have One
What is a Roth IRA and Why Your Kid Should Have One

The last thing on the mind of most kids and teenagers is saving for retirement, but opening a Roth IRA while you’re still a student is a great financial strategy. Roth IRAs can be used to save for various other life events other than retirement. They can be used for higher education costs, saving for a down-payment and the purchase of a first home, and can also be used to pay certain medical bills and health insurance premiums when certain conditions apply. In this simple guide to Roth IRAs for kids and teens, we’ll discuss what is a Roth IRA and if it is right for you or your teenager, pre-teen, or college student.

What is a Roth IRA

A Roth ira is an individual retirement account to which one contributes after-tax dollars. While there isn’t a tax deduction for the contribution, your Roth IRA earnings will grow tax-free. You can always withdraw your initial contribution without penalty.

Why Every Kid should Open A Roth IRA

Time is On Their Side

We all know the adage “time is money” but there is nothing more true than that when it comes to investing. The power of compounding earnings increases the longer an investment grows. Getting a head start on retirement savings will really pay off over time.

Erning Money from Dog Walking
Earning Money from Dog Walking

Here’s an example: If your teenage daughter does pet sitting and dog walking over her summer vacation, she’ll have earned income. If she contributes just $2000 a year from the time she is 13 until she graduates from college at 21, her Roth savings will grow to approximately $24,000 when she graduates (assuming an average rate of return of 6%).

It makes sense to be making ROTH IRA contributions in those early years when you’re not earning as high an income. You’ll most likely be in a lower tax bracket than in future years when hopefully you’ll be earning more.

Penalty-Free Withdrawals

Roth contributions can always be withdrawn tax and penalty-free. There are also special exceptions where you can also withdraw earnings penalty-free:

  • Higher Education Costs: Withdrawals may be made penalty-free for higher education costs of the taxpayer, the taxpayer’s spouse, child, or grandchild. Withdrawals of contributions will not be taxable, but earnings withdrawn will be taxable.
  • First Time Home-buyer Withdrawl: Perhaps your daughter will be like my mine, who though she’s just 21 has her sights set on buying a home in the next year or so. We opened her Roth IRA just a few weeks ago. When I explained to her the 5 year rule she turned to me and said “Mom you should have opened this for me when I was like 5 years old.” She isn’t wrong. The 5 year rule allows the withdrawl up to $10,000 in earnings tax and penalty-free for the purchase of a first house provided that your Roth IRA account has been open for 5 years.
  • Use as An Emergency Fund: Roth earnings can be withdrawn and used to pay medical bills when the medical bills exceed 10% of your adjusted gross income. The withdrawal will be subject to tax but not penalties. Tax and penalty-free withdrawals can also be made to pay for health insurance premiums while unemployed.

Retirement Tax Credit

ROTH IRA contributions are eligible for the retirement tax credit, but sadly students aren’t eligible for this credit. However, if your teen or young adolescent is taking a gap year or is no longer a student they may be able to claim the retirement tax credit.

The maximum contribution eligible for credit for a single taxpayer is $2,000, and if the taxpayer’s adjusted gross income is less than $20,500 they’ll receive a tax credit of up to 50 % of their contribution, so a $2,000 contribution could yield a $1000 tax credit. It’s important to note that this credit is non-refundable meaning that if you don’t owe $1,000 in taxes your credit would be limited to what you actually owe.

Another group of taxpayers that can often take advantage of the retirement savers credit is small business owners in the start-up phase of their business. Oftentimes these businesses aren’t very profitable in the first year or two or have large start-up expenses that leave them with little taxable income.

As a CPA, I always recommend those eligible for the Retirement Tax Credit to take advantage of it. Where else can you get up to a 50% instant return on your money?

Instills Good Financial Mindset

Starting saving at a young age instills a good financial mindset. It’s been proven that success is linked to mindset, a good financial mindset can pave the way to success. A youngster that is taught good financial habits while young is much less likely to fall prey to the temptations of debt, watching their money grow is much more fun than trying to figure out how to pay credit card bills.

Couple Struggling to Pay Bills
Saving is More Fun Than Struggling to Pay Bills (Photo by Mikhail Nilov from Pexels)

Better Yields than a Savings Account

Your teen will thank you for your advice to open a Roth IRA when they see how much their money is growing. There is so much more earning potential with a Roth IRA than the traditional savings account opened for youth.

Who is Eligible to Make a Roth IRA Contribution

The following criteria must be met to make a Roth IRA contribution:

  • The taxpayer must have earned income of at least the amount of the contribution for the year;
  • For 2022 a single taxpayer’s adjusted gross income must be less than $144,0000,with contribution phase-out starting at $129,000 (most kids won’t have a problem meeting this eligibility requirement!)
  • Contributions must be made by April 15th of the year following the tax year for which the contribution is being made.

Some parents fear that to meet the eligibility guidelines above their child would need to file a tax return. Happily, if your child is not otherwise required to file a tax return, making a Roth IRA contribution will not obligate them to file a return.

Contribution Limits

The 2022 maximum Roth IRA contribution limit for those under 50 is $6,000 and for 2023 the maximum contribution limit for those under 50 is $6,500. There is no minimum contribution limit. So even if your child has just a hundred dollars in earnings from little jobs they can contribute to a Roth IRA.

Best Place to Open A Roth IRA

Since the goal of saving via a Roth IRA should be long-term investment growth it makes sense to open an account where you have a good selection of investment options. You will not get maximum growth opening a Roth at a bank.

For your first Roth IRA account look for a low minimum account opening balance and no fees.

Some brokerages like Fidelity will offer account opening incentives of $50 or $100 just for opening and funding an account. That’s a great way for new investors to get their retirement savings off on the right foot. Fidelity offers a wide array of investment products including target retirement funds based on the age of the investor.

Robo-advisors such as Betterment, Wealthfront, and Fidelity Go are gaining in popularity. Their financial professionals manage your investments for a small fee (Fidelity Go waives fees for accounts less than $10,000 and also has no minimum balance). Their returns have historically justified their fees, and they are a good choice for hands-off investors. They have apps that appeal to young investors as they can literally watch their earnings grow, and they offer sustainably responsible investing options.

When to Contribute to a Roth IRA?

Yesterday. Seriously, as soon as possible.

Many beginner investors save their money up and then make a large annual contribution to their Roth IRA. This is not a good financial strategy. It’s wiser to invest in your Roth IRAmonthly for several reasons:

  • Out of sight out of mind-if the money is not accessible it’s less likely to get spent;
  • Financially it’s been proven that “Dollar Cost Averaging” (the name for periodic purchasing vs lump sum) yields better returns;
  • Won’t miss the deadline: Many of us are procrastinators and likely to miss the deadline if we don’t set up automatic contributions.

No amount is too small to contribute, after-all something is better than nothing. The whole idea of Roth IRAs for kids is letting time do its thing and teaching a good financial mindset.

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A Simple Guide to Roth IRAs for Kids and Teens
A Simple Guide to Roth IRAs for Kids and Teens

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