Liz Weston, NerdWallet
Gary Sidder set up Roth IRAs for his sons when they turned 13. Each year, the Littleton, Colorado, certified financial planner and his wife, Francie Steinzeig, a school psychologist, contributed an amount equal to whatever the two boys earned cutting lawns, shoveling snow and doing odd jobs. As the sons’ earnings increased, so did the parental contributions.
“Initially we started with $400, and now we do $5,500 for each,” the annual maximum allowable contribution, says Sidder, whose sons are 32 and 27. “Now that their accounts are worth more than $100,000 and $65,000, respectively, they do see the value of saving and starting early.”
Even if no further contributions are made, both sons could see their accounts top $1 million by retirement age, assuming conservative 7 percent average annual returns.
Financial planners know that Roth IRAs can set kids up for sound financial futures. Since children have decades ahead for money to compound, even relatively small contributions can grow large. The catches:
• The kids must have earned income from real work. That includes reasonable wages or income from self-employment. The Roth contribution can’t be more than their total earnings for the year, up to $5,500.
• Kids under 18 need a custodial Roth. Not all brokerages have attractive options for small accounts. Fidelity and Schwab, however, offer custodial retirement accounts with no opening or maintenance fees. Fidelity has no minimum, while Schwab requires at least $100 to open the account, and both offer commission-free trades on certain mutual funds and exchange-traded funds.
Why a Roth rather than a traditional IRA? Low-wage workers pay little if any income tax, so they don’t get much value from tax deductions, including deductible contributions to a traditional IRA. When a big upfront tax break isn’t available, it makes sense to contribute instead to a Roth. Contributions aren’t deductible, but withdrawals in retirement are tax-free.
Another important note: Retirement accounts aren’t included in federal financial aid formulas, so a child’s Roth won’t affect financial aid offers from most schools. Some private schools, however, do consider custodial Roths when calculating their offers, says college financing expert Lynn O’Shaughnessy, author of “The College Solution.” Also, withdrawals from Roths during college years would be considered income to the child and count heavily against her, O’Shaughnessy says.
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HOW ROTH IRAS WORK
The ability to contribute to a Roth starts to phase out above certain modified adjusted gross income levels. For 2017, the phase-out begins at $118,000 for singles and $186,000 for married couples filing jointly.
That’s not an issue most kids have to worry about. Let’s say your daughter works 30 hours a week for the federal minimum wage of $7.25 per hour this summer and earns about $2,600 over 12 weeks.
Obviously, she won’t net $2,600 from her job. She’ll lose 7.65% to payroll taxes and want to spend some of the money she earns. But you can contribute $2,600 for her, or offer matching funds for whatever she contributes. If she continues those $2,600 contributions for the next 50 years, her Roth can grow to $1 million, assuming 7 percent average annual returns.
That far in the future, $1 million will be worth the equivalent of about $230,000 today, assuming 2.9 percent inflation. Once she’s in the working world full time, encourage her to contribute at least 15 percent of her income toward her retirement and keep doing so throughout her career.
You can talk about that with her as you’re setting up her Roth. Together you should also:
• Review her investment options. Fees can devastate small accounts and dramatically lower the amount she can accumulate over decades, so low-cost index funds or exchange-traded funds might be a good choice.
• Discuss the temptations for tapping the money. Technically, she can withdraw an amount equal to the contributions at any time without paying taxes or penalties. She also can withdraw up to $10,000 for a first-time home purchase, or money to pay college expenses, without taxes and penalties after the account has been open five years.
• Underline the payoff for leaving the money alone to grow. The best use of retirement money is for retirement, and it can grow to seven figures only if she keeps her mitts off it.
“Parents could use this to teach a valuable lesson in delaying gratification and building investments over time,” says John Gugle, a certified financial planner in Charlotte, North Carolina. “This is a marathon, not a sprint.”
