By the time you read this, you might be thinking, “The summer is almost over.”
That doesn’t change anything. Believe it or not, it’s not too late to take full advantage of this summer job opportunity. In fact, you probably have until next April to make your final decision.
Unfortunately, most times teenagers only think of summer jobs in terms of short-term goals like movie money, buying a car or even paying for college.
Those who have the future in mind, however, understand the true long-term benefit a summer job offers. Teen earnings qualify for IRA contributions, and that can yield tremendous returns when your child retires. For example, saving the maximum annual contribution in a Child IRA ($6,000) each year from age 13 through age 18 grows to $2½ million dollars at age 70 (assuming an 8% annual growth rate).
This isn’t rocket science. It’s straight-forward math that everyone can understand.
If it’s that simple, why doesn’t everyone do it?
Retirement advisor Jonathan DeYoe, President of Mindful Money in Berkeley, California, uses this approach. He has two teenagers and he’s set up Roth IRAs for both of them. He’s one of several financial professionals who grasp the significance of a Child IRA and have been quick to seize this opportunity for their own children.
Yet, DeYoe notes many parents don’t do this for a variety of reasons. “They are bad enough at funding their own IRAs,” he says, “and they don’t know that this is an option.” Furthermore, he adds “Their advisors are not thinking of the very long-term (or don’t understand the incredible power of funding the Roth IRA for a 12-year-old, namely 60 years of compounding).”
Naturally, the 7-digit retirement growth at age 70 sounds incredible even to you, but you might worry that this pot of gold at the end of the Child IRA rainbow lies too far in the distant future to entice your child. Worry not. Most children are impressed by 5-digit dollar amounts, and that’s achievable in a short time frame.
Speed is of the essence to make the lesson hit home. The Child IRA rapidly becomes an educational tool (no matter what your child’s age).
“They learn about the power of saving and the power of compounding,” says Arvind Ven, CEO of Capital V Group in Cupertino, California. “If they can learn discipline through deferred gratification, that will be an added bonus. If the funds compound even in single digit percentages on average every year, they could have a seven-figure nest egg (tax free if it is a Roth) at retirement.”
While you shouldn’t discount the growth aspect of using your teen’s summer earnings to begin funding a Child IRA, these vehicles offer plenty of other rewards.
“There are many advantages for younger people to set up Child IRA accounts,” says Jason Field, Financial Advisor at Van Leeuwen & Company in Princeton, New Jersey. “These types of accounts are great for introducing children to the investment world and teaches them about earning and saving money for long-term goals. Traditional IRA’s can offer current tax deductions if the child files a tax return, and Roth IRA’s can offer tax free growth and no required minimum distributions.”
Many parents enjoy setting up bank accounts for their young children as a way to introduce them to the wonderful world of high finance. In fact, banks often offer special “child savings accounts” to encourage this.
Child IRAs, on the other hand, provide a more powerful punch to the objective of teaching your children what they need to learn about money. And unlike a traditional bank savings or checking account, they place a natural limit on premature withdrawals. Parents who worry about their child’s spending discipline might find this appealing.
“Child IRA’s make excellent savings vehicles for teens,” says Jazmin Gabriela Carpenter, VP, Investments at Wedbush Securities in Los Angeles. “Their youth and the decades they have ahead of them, give them tremendous advantage when it comes to investing. It can provide them with valuable financial lessons such as earning, saving and spending which is a component of Financial Literacy. Let’s not forget the important lesson of compounding which, for their age, works best as they have time on their side. Another advantage is they could use the funds for other important expenses such as education expenses (they will have to pay taxes on the earnings but there is no 10% early withdrawal penalty if the money is used for qualified education expenses like tuition, books and supplies), or buying a home (they can withdraw funds to use as a down payment or closing costs before reaching age 59½). The maximum that can be withdrawn for this purpose is $10,000.00. These early withdrawals are penalty and tax free. However, it is always recommended keeping these funds intact, if at all possible.”
So, just how does the teen set up an IRA to contribute those summer earnings into?
Well, there’s bad news for teens seeking independence. They can’t do this alone.
“To open a Child IRA, a parent, guardian or other adult will need to open the account on behalf of a minor,” says Tiffany Lam-Balfour, investing and retirement specialist at NerdWallet in San Francisco.
When you set up this Child IRA, you’ll need to decide whether it will be a traditional tax-deferred IRA or an after-tax Roth IRA. For most teenagers, one option is the clear winner.
“When it comes to setting up an IRA for a working child, I would hands down recommend a Roth IRA vs. a Traditional IRA,” says Mike Cocco, Financial Professional at Equitable Advisors in Nutley, New Jersey. “Roth IRAs do not get a tax deduction up front, but that’s OK! Most teenagers or college students may have income so low that they pay little to no income tax anyway, so that tax deduction may be meaningless. However, Roth IRAs grow tax-deferred, so you don’t have to declare the dividends and interest each year on their taxes like a normal investment account. And they are also tax-free (even the earnings!) if they keep it until age 59 ½… so over decades of savings and investing, those gains can be quite substantial and potentially accessed all tax free.”
No matter what kind of job your teen is enjoying this summer, don’t miss out on this (literally) once in a lifetime opportunity to begin to build a valuable financial education as well as a good strong base of a fruitful and relaxed retirement.
“Setting up an IRA helps to kickstart teens’ retirement accounts and also helps develop healthy investing habits,” says Nicklas Norvell, Wealth Management Advisor & Chief of Staff at Croak Asset Management in Toledo. “I like to see kids get started young and get comfortable with the idea of saving and investing before they start making real money. Utilizing a Roth IRA while young for future high earners is also an extremely popular strategy.”
And, remember, it’s not too late. Just like any other IRA, you don’t have to contribute this year’s earnings until next April.