Your child should invest in a Roth IRA
Parents desire to leave their children better off than they were themselves. That simple wish has long been part of the American dream. Most of us will spend many years and decades building wealth, with the hope of having enough remaining at the end of our lives to leave to the next generation. However, there is a simpler way to build your kids’ wealth – a Roth IRA.
Many people think of an Individual Retirement Account (IRA) as an investment vehicle to be opened once they have finished their formal education, secured fulltime employment and possibly obtained a mortgage or a car payment. I think the exact opposite should be true – children should begin investing for their retirement as early as possible in their lives.
A Roth IRA has no minimum age and grows tax-free. Children have many decades, perhaps even half a century, to invest and build wealth. For example, a one-time contribution of $5,000 invested at an average 12% return in a decent mutual fund will grow to approximately $1.96 million over 50 years. Put in an additional $10 per month to make that $2.3 million. A more conservative investment return of 10% will grow to about $725,000 over the same length of time, or about $900,000 with the $10 monthly contribution.
Although a Roth IRA has no age limitation, the child must have earned income. Summer work or after-school jobs are a possibility, but there are other ways of earning income. For instance, your child may cut grass or baby-sit. Alternatively, you may be self-employed and hire your child to perform work for your company. The bottom line is that if your child earns income, they are on the way to funding their Roth IRA.
Here is the basic process:
1. The child earns income from employment (including working for you) or self-employment.
2. The child receives a W2 or 1099-MISC.
3. The child files a tax return if required (especially in the case of self-employment or receiving income reported on a 1099-MISC).
If the child is self-employed, their only federal tax liability may be self-employment tax if the earned income is below the federal standard deduction ($12,400). If the child receives a W2, payroll tax has already been withheld. Since children are often in the zero percent income tax bracket, they often pay no income tax on their earnings. Since there is no income tax on Roth IRA distribution in retirement, this is a terrific way to build wealth nearly tax-free.
As a parent, you can gift your child the necessary funds to cover their taxes. You may also choose to match your child’s IRA contributions or gift them outright, so long as the contribution does not exceed their earned income.
The mechanics of this investment vehicle are simple and straightforward. The child can even be a minor – the parent just needs to open a custodial account with their preferred investment advisor or company.
I think this is a better strategy than savings bonds or putting money in a savings account that earns practically nothing. While it is certainly important that you save for your own retirement, it can be a great way to start the next generation on their way to financial freedom as well. If you have children, now is the time to help them prepare responsibly for their financial future. Speaking of being responsible, consider reading Smart Money, Smart Kids by Dave Ramsey.