Congratulations, you are now a seasoned investor. You have been saving for years and now have a sizeable portfolio. You want the same for your kids. But that brings along many questions, like…
- How do you get them to catch the investing bug?
- What type of account should they open first?
- What if they do not yet earn enough to make sizeable contributions?
When my kids (ages 10, 9, 2, and baby) are old enough, the first account I will encourage them to open is a… (drumroll please…)
Roth IRA: starting early & starting small
Obviously, the correct answer to “when should I start saving?” is “as soon as possible!” But sometimes we get the wrong idea of just how soon that really is. I know it seems like common sense, but remember that saving something is better than saving nothing – even if only a dollar a month! It may not get you very far, but good habits start small.
The Roth IRA, in particular, is built to reward those who keep this in mind. Because Roth contributions are made after taxes, these accounts are best used by those who:
- Are in a low tax bracket; and
- Have time for their investments to compound.
Both of which are almost certainly true of your young starving artist or Ramen-powered post-grad. Your child’s temporarily low tax bracket will make for big savings over the life of the account, and will allow them to make the maximum contribution (currently set at $6,000/year) should they have the means to do so.
In case you aren’t convinced, consider an example. On the one hand, we have a Roth IRA that is opened when the accountholder is 25 years old, with a starting balance of only $1000 and annual contributions well below the limit. On the other, one opened with a more respectable $10,000 when the accountholder is 45, and with maximum annual contributions.
Assuming retirement at 65, annual returns of 7%, blah blah blah and so on, here is how those two accounts will approximately end up:
Yep – once again, slow and steady wins the race! While your kid may not see the proverbial tortoise as a fun role model, this is some pretty good evidence that that old fable is onto something.
Flexibility for the Future
Roths are primarily intended for retirement savings, of course, and so some restrictions apply.
- You may only contribute $6,000/yr or 100% of earned income – whichever is less
- You may not contribute if your AGI is over $144k ($214k if married) in 2022
- Your investment gains may not be withdrawn until:
- You are 59 ½ or older; and
- The account has been open & funded for at least 5 years.
For a youngster, waiting until 59 ½ is like… in the future, dude! And locking away money for that long may seem unnecessarily limiting. BUT the good news is that the principal (contributions) made to a Roth are always 100% tax- and penalty-free, regardless of age.
I would not recommend pulling from Roth before retirement, but if your young adult is concerned about leaving her options open, a Roth will allow her to save in a tax-wise manner without feeling so trapped.
Another bonus: if your child earns very little right now and cannot afford to save money, but you still want them to get a head start on investing principles, you can gift money for him or her to invest in a Roth!
Yes, Rule #1 above states that contributions may not exceed earned income; but this does not mean parents are unable to pitch in. Rather, the IRS rule only requires that the amount contributed may not exceed the amount the account owner (your child) earned in taxable wages/commissions/etc.
So as far as the IRS is concerned, her Roth contributions were made with her earned income, while the cash gift you gave her was used to cover living expenses. And they are fine with that. After all, nowhere in the tax code does it say that a Roth holder must live on earned income alone.
In Conclusion (with a caveat)
As always, there are exceptions. If your child will be going to school next year and will be applying for FAFSA they will need to focus on reducing their reportable income to $7,040 (in 2022) or less if they are to maximize their student aid – in which case the before-tax contributions of a traditional IRA may be preferable.
But all else being equal, the long time horizon and low tax bracket of youth is a great recipe for Roth success.