You may not be able to turn back the clock to open your own retirement accounts earlier, but you can set your children and grandchildren up for success with a Roth IRA for kids. Here’s what you need to know.
Compound Interest: Time Is on Your Side
When you invest your money over a longer period of time, you’ll see exponential growth by the time you’re ready to retire—and that’s all courtesy of the magic of compound interest. For a snapshot of its power, think about a $100 per month investment that you make for 50 years. Sitting in a checking account earning no interest at all, you’d have $60,000 at the end of your investment period.
If you earn compound interest on that amount—meaning that every year you earn 5% interest the amount you have saved so far—you’ll earn interest on your interest as well as your principal savings, and your total will skyrocket. With a 5% average annual return compounded annually on our little $100-a-month account, you’d have over $250,000 after 50 years. At a 10% average annual return you would have nearly $1,400,000 after 50 year investing just $100-a-month.
It pays to start early.
Roth IRAs for Children: Tax Free Investing
To get your children or grandchildren started early on investing, you can open a custodial Roth IRA. As the custodian, you will control this account on their behalf until they reach adulthood.
A Roth IRA is ideal for children because of the way its tax advantages are structured. With a Roth, your child contributes post-tax income to the account, up to a maximum of $6,000 per year.
But here’s the thing: Kids don’t earn much money, so they’re unlikely to owe any taxes on their earnings anyway. Dependents are subject to a reduced standard deduction, but it’s still more than $6,000—which means they can max out their Roth IRAs without paying taxes on any of that income.
Because the earnings on a Roth IRA are tax-free, your child can reap the benefits of decades of compound interest without ever paying taxes on that money. They won’t be taxed on what goes in, and they won’t be taxed when they take distributions later.
Important Roth Rules for Kids
Like adults, kids must have earned income to contribute to a Roth IRA. For teens, this can be from standard life guarding and burger flipping W-2 jobs. Earned income can also be in the form of money earned for odd jobs like tutoring, babysitting, or even operating a lemonade stand. The key is to make sure you track income from these odd jobs by keeping receipts or a log so you can prove your child actually earned the money—it can’t be a gift from you.
Your child can invest 100% of their earnings up to the maximum of $6,000 per year. If you want to let them keep their money and “give” them the cash to invest in the Roth yourself, that’s fine. As long as the total in the account doesn’t exceed their earnings, the IRS won’t care.
Looking for a great Roth IRA for your kids or grandkids? We’re here to help with all your investment needs, so contact us today.