Give Your Teen a Financial Head Start with a Roth IRA

As parents, nurturing our children’s financial well-being is a top priority. While teaching them the value of money and responsible spending habits is crucial, setting them up for long-term financial success requires more than just piggybanks and budgeting lessons. One powerful tool that parents can utilize is the Roth Individual Retirement Account (IRA).

A custodial Roth IRA is a tax-advantaged retirement account owned by a minor but controlled (and possibly funded) by an adult custodian until the minor reaches legal adulthood. It’s very similar to a typical Roth IRA yet offers additional flexibility.

Here’s why parents should consider opening a Roth IRA for their teenage child:

1. Early start, maximum impact

Time is the greatest ally of any investor, and the earlier you start saving for retirement, the better. By opening a Roth IRA for your teen, you’re giving them a head start on building wealth for the future. The power of compounding means that even small contributions made during their teenage years can grow into substantial savings by the time they retire.

The maximum amount your teen can contribute annually for 2024 is $7,000, or the total amount of taxable compensation he or she earns during the year, whichever is less (assuming your teen does not exceed the adjusted gross income limit for Roth IRA contributions). For example, if your child earns $2,000 from a summer job, they can contribute up to $2,000 to a Roth IRA. That single $2,000 investment made today could be worth more than $93,803 in 50 years, assuming an 8% annual return.

2. Tax-free growth

One of the most significant benefits of a Roth IRA is the tax treatment of contributions and withdrawals. Since contributions are made with after-tax dollars, any investment gains in the account grow tax-free. This means that your teen can potentially accumulate a sizable nest egg without having to worry about paying taxes on their earnings when they withdraw the funds in retirement. They also avoid any reduction of investment return due to annual tax liability. For example, if the annual return were reduced by 1% for tax payments, the net return in the above example would be 7%. A $2,000 investment made today would be worth $58,914 after 50 years.

3. Withdrawals don’t have to wait until retirement

While Roth IRAs are primarily intended for retirement savings, there are two ways your child can access the investment earnings before age 59 ½:

• After the Roth IRA has been funded for five years, your child can take out up to $10,000 in earnings to buy a first home, tax and penalty-free.
• Roth IRA earnings can be used for qualified education expenses, such as college tuition. Earnings distributed will be taxed as income, but there will be no penalty.

It’s important to remember that, unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs). That means the account can continue to grow for your child’s lifetime, making it an ideal wealth-transfer vehicle.

4. Anyone can contribute

If your teen meets the earned income requirement, you or anyone else can contribute on their behalf. Some families choose to implement matching funds, meaning the parents match whatever the child contributes. The good news is that in this case, the parents’ income threshold doesn’t matter. The only income the IRS cares about is the child’s.

A decision that can pay dividends for years to come

Ultimately, opening a Roth IRA for your teen can be a useful gift to assist with financial security. By taking advantage of the unique benefits of a Roth IRA and involving your teen in the process, you can help provide them with a valuable financial tool and instill important lessons about saving, investing, and planning for the future. For more information, contact your wealth advisor. And if you are not a client, let’s talk.