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Why Your Kid Needs a Roth IRA

April 12, 2018
Investing, Roth IRA
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A Roth IRA isn’t typically considered a savings vehicle for kids, but it should be.

Yes, the “R” in IRA stands for retirement, which probably doesn’t make the list of things most minors are saving for. But Roth IRAs aren’t just for retirement — they’re actually ideal for kids. The decades ahead mean money contributed has more time to grow tax-free.

Quick facts about Roth IRAs for kids

  • Kids of any age can contribute to a Roth IRA, as long as they have earned income.
  • A parent or other adult will need to open the custodial Roth IRA for the child.
  • A Roth IRA is more flexible than other retirement accounts because contributions can be withdrawn at any time.

» Need the basics? Read our guide to Roth IRAs

When a child can have a Roth IRA

Even the Gerber baby can contribute to a Roth IRA: The hurdle to opening this account is about income, not age.

If a kid has earned income, he or she can contribute to a Roth IRA. Earned income is defined by the IRS as taxable income and wages — money earned from a W-2 job, or from self-employment gigs like baby-sitting, lawn care or dog walking.

The Roth IRA contribution limit is $5,500 a year, or the total of earned income for the year, whichever is less. If a child earns $2,000 baby-sitting in 2018, he or she can contribute up to $2,000 to a Roth IRA.

Some parents want to contribute to a Roth IRA for their children or to match a child’s contributions. In that case, the child must still have at least as much earned income as the total contribution amount.

Why a Roth IRA is right for kids

Now that you know whether your kids can have a Roth IRA, you might be wondering if they should. The answer is yes. Aside from the momentum of investing early, there are several reasons why a Roth IRA in particular is a good choice for children:

1. Contributions can be withdrawn at any time

Retirement accounts are known sticklers about distributions; many charge a 10% penalty on money taken out before age 59½. That’s tough on kids, who aren’t exactly known for their ability to delay gratification.

But a Roth IRA is different. The money contributed to the account can be withdrawn at any time and used for anything from a Matchbox car to a first real car.

That flexibility is balanced by stricter rules for the Roth IRA account’s earnings, or the return on contributions that are invested. Distributions of investment earnings may be taxed as income, penalized with a 10% early distribution tax or both.

Those two rules make the Roth IRA a nice middle ground between kids who want easy access to their cash and parents who want to make sure some of that cash is saved for the future.

» Get the full details on Roth IRA early withdrawals

2. More time means more growth

There’s a fun phenomenon called compound interest that works like this: Given time, invested money earns more money. Most of us have 30 or 40 years until retirement once we start investing; a kid who starts earlier has the benefit of much more. If your kids leave their money in the Roth IRA until retirement, they could be looking at 50 or more years of investment growth, completely tax-free.

Is waiting that long a hard sell? Show them this chart, which illustrates what a $5,500 Roth IRA contribution could become if invested for 10, 20, 30, 40, 50 or 60 years.

3. Investing trumps saving

That type of growth wouldn’t happen in a plain savings account, which is the more traditional choice for kids because it’s flexible and doesn’t require earned income. Unlike in a Roth IRA, birthday money is welcome.

But a Roth IRA allows your kids to pick and choose investments, which, over the long term, is what can lead to the kind of growth illustrated above. Savings accounts instead pay a relatively flat interest rate that currently hovers around 0.07%. That’s a far cry — and many thousands of dollars — away from the 6% or more you can expect to earn annually from a long-term investment. Even at a 1% interest rate — paid by many online savings accounts today — a one-time deposit of $5,500 won’t double after 50 years.

There are trade-offs, of course: Most notably, your kids could lose the money they invest in a Roth IRA, though history tells us that’s unlikely to happen if they stick to a diversified portfolio over a long period of time.

4. The tax advantages are prime for kids

The Roth IRA works like this: Because there’s no tax break for putting money into the account, qualified distributions in retirement are not taxed. All that growth we keep talking about is earned completely tax-free if your kid follows the rules for distributions.

The Roth’s tax treatment is especially valuable when your time horizon is long and your current tax rate is low, and both of those are true for children. In fact, the earnings of most kids are so low that they pay little to no income taxes, meaning they avoid taxes on contributions, too.

5. The money can be used for more than retirement

Yes, a Roth IRA is a retirement account. The ideal goal is to sit on the account and allow it to accumulate a nice pot of cash over time. But it’s worth pointing out that a Roth IRA isn’t just a retirement account.

Again, contributions can be pulled out for any reason. But there are also a couple of loopholes that can get your kid access to the investment earnings before age 59½.

  • 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, like college tuition. Earnings distributed will be taxed as income, but there will be no penalty.

How to open a Roth IRA for your kids

Your child’s income is what makes him or her eligible for the Roth IRA, but a parent or other adult will have to help open the account. Roth IRA providers typically require an adult to open and manage a custodial Roth IRA on behalf of a minor. Unfortunately, not all online brokerage firms or banks offer custodial IRAs, but Fidelity and Charles Schwab both do.

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