Since most young adults are in a very low tax bracket, even 0%, a Roth IRA may be the perfect way to … [+]
You don’t have to be an adult to begin saving for retirement. Provided the teenager or college student has earned income, perhaps from a part-time job, they’re able to fund an IRA—even if a parent, grandparent, or relative is the one making the contribution. Given that most young adults are in a very low tax bracket, even 0%, a Roth IRA may be the perfect way to help your child begin to save and invest for their future.
Help make future millionaires
Everyone wishes they started saving earlier for retirement, but few seriously consider it while still in high school. For those who start investing early, the benefits can be significant and lasting. When investment returns compound, investors earn a return on their return. This is compounded growth. Over decades, compounding allows your invested dollars to work much harder for you than if you were only invested for a shorter time horizon.
Here’s an example of compounding in action:
Imagine Millie is 16 years old and works as a lifeguard and camp counselor throughout high school and college. She earns $7,000 per year and contributes $3,000 to a Roth IRA, which her parents match 100%, for a total of $6,000 (the IRS limit in 2019). When Millie turns 22, she graduates college and starts a full-time job as a software developer. She now makes the full $6,000 contribution by herself throughout her 20s before her income precludes her from making regular contributions.
From age 16 to 29, Millie (and her parents) have contributed a total of $84,000 to her Roth IRA. Assuming a 6% annual rate of return, by age 65 her account would be worth $1,088,928.
How Roth IRAs are unique
After-tax contributions
Contributions to a Roth IRA are made with after-tax dollars, meaning you pay tax today instead of deferring it until later. Since teens and young adults typically have limited income, this could mean paying tax at a 0% rate! Generally, the higher your tax bracket, the less advantageous a Roth IRA can be.
Tax-deferred growth
Like a traditional IRA or 401(k), investment growth in a Roth IRA isn’t taxed each year. Since more dollars stay invested, the account can grow faster than a taxable asset when funds are needed to pay an annual tax liability.
Tax-free in retirement
Assuming at least five years have passed since the first contribution was made and the account owner is at least age 59 ½, withdrawals from a Roth IRA are completely tax-free. This includes both original contributions and investment growth. Early withdrawals may be subject to tax on investment growth and a 10% penalty, though there are some penalty exceptions.
No required minimum distributions
Unlike traditional IRAs, 401(k)s, and all other types of retirement accounts, there is currently no requirement forcing individuals to take annual distributions from a Roth IRA, called required minimum distributions (RMDs). Without mandatory withdrawals starting at age 70 ½, a Roth IRA can be a great way to add flexibility and tax diversification in retirement.
A Roth strategy isn’t for everyone
Income limits prevent many high-earning taxpayers from making regular contributions to a Roth IRA. In 2019, the phase-out range for single filers is between $122,000 – $137,000 and for married couples filing jointly $193,000 – $203,000. However, as previously mentioned, the benefits of a Roth IRA generally begin to decline as earnings increase if taxpayers are in a higher marginal tax rate today than they would be in retirement. There is no income limit on annual Roth IRA conversions.
Due to the relatively low annual contribution limit (the lesser of the individual’s earned income or the stated IRS limit, which is $6,000 in 2019 for individuals under age 50), it can be difficult for some to build a sizable Roth IRA nest egg before income eligibility becomes an issue. The benefits of this strategy are most significant when contributions are made for several years, especially 10 years or more.
This strategy is most effective when funds are preserved for retirement, so if your child may need the funds beforehand, you may want to consider using a high-yield savings account or a brokerage account instead.
Teaching teens and young adults about money
Helping your child start saving and investing with a Roth IRA provides an opportunity to share valuable lessons about money, investing, saving, and budgeting. Even if you match their contributions or fund the account on their behalf, having an investment account in the child’s own name still creates a sense of ownership. Between monitoring performance, picking investments, and funding the account, there are no shortage of teachable moments to expose your teen or young professional to valuable life lessons about building wealth and personal finance.