Roth IRA: Jump Start Your Child’s Retirement Fund

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Do you have a high school- or college-age child in your life? Knowing what you know now, I bet you’d like to give that special person a head start on retirement savings. Right? The good news is, if your child worked in 2018, you might be able to do just that. Here’s how!

Can My Child Start an IRA?

If your high school or college student had a summer job or other part-time employment during 2018 he/she is eligible to contribute to an IRA. For 2018, that amount is $5,500 or the total amount of earned income, whichever is less. So, if your son earned $1,500 last summer, he can contribute up to $1,500 to his IRA. If your daughter earned $7,000, the maximum she can contribute is $5,500. Next tax year it gets even better. The limit will increase to $6,000.

One important caveat to note: Earned income does not include dividends, interest, or capital gains received from an investment portfolio. Earned income constitutes wages paid by an employer who withheld taxes and reported the earnings to the Internal Revenue Service. If your child’s income comes from babysitting, mowing lawns, or doing odd jobs around the neighborhood, he/she must maintain careful records to qualify as "self-employed."

Roth Versus Traditional IRA

If your child is eligible, you need to select the type of IRA in which to invest. Traditional IRAs are generally not the best choice for students. Since most students pay little or no taxes, the tax deduction they’d receive for a contribution to a traditional IRA isn’t that beneficial. Plus, any eventual withdrawals from a traditional IRA are taxed as income. While that may not be a big consideration now, it could be important to your child later in life.

As a tax-free retirement savings vehicle, a Roth IRA offers the greatest opportunity for growth. While Roth IRA contributions aren’t deductible, earnings and future withdrawals in most situations are not taxed.

Establishing a Roth IRA

As a minor, your child will need an adult to open a custodial Roth IRA. The “named custodian” doesn’t have to be the same as the contributor to the IRA. For example, a grandparent might wish to provide funds, but may not want the custodian responsibilities. Once the child attains adulthood, he/she will then control the account.

Contributions (not investment earnings) can be withdrawn tax-free and penalty-free anytime, regardless of the account owner’s (the child’s) age.  Investment earnings withdrawn prior to the owner being age 59 ½ will be taxed and subject to a 10 percent penalty. However, there are exceptions. If the earnings withdrawn are used for qualified education expenses, taxes must be paid, but no penalty will be applied. This means your child’s Roth IRA can also supplement other accounts that have been designated for college expenses.

Would My Child Contribute?

Your child is likely saving for college or accumulating cash for future expenses or purchases such as a car or a special school trip. Saving for retirement is probably the last thing on his/her mind!!  But, here’s the great thing about an IRA - contributions can come from any source. Parents, grandparents, or any other person can gift the contribution to your child’s Roth IRA. No gift tax will be due as long as the total calendar-year value of all gifts from any one person is $15,000 or less. That’s a win-win for everyone!

Want to make a big impact on your child’s financial future? Supplement your student’s summer earnings with a Roth IRA contribution. It all adds up. For example, if you make an annual $2,000 contribution from the time your child is age 15 to the time he/she is 22, and it earns an 8 percent return every year, your contribution would be worth nearly $500,000 when your child turns age 62. Even a relatively modest $500-per-year contribution would grow to nearly $125,000. And remember, this is tax-free money your child can use during retirement or to pass along to his/her heirs.

Summary

This Roth IRA account alone is unlikely to meet all your child’s financial needs. But it does provide a head start for a financially secure future. Obviously, this is a long-term investment. Your child will probably not fully appreciate your generosity today, but as your child grows so will the account and (hopefully) his/her gratitude.

David Crossman, CFA, is a Senior Portfolio Manager with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website or email David.

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