It is a little known fact that children who earn an income can open a Roth IRA.
Parents who have this knowledge can help their children learn about the power of compound interest and its near magical effect on retirement savings.
What Are the Requirements for Opening a Roth IRA for a Child?
A child can open a Roth IRA if they have verifiable income. Their income can be verified through W-2 records, or if they were a freelancer, so to speak, mowing lawns or babysitting, they must claim their income on a tax return.
In addition, some brokers also request that a legal guardian be on the Roth IRA with the child until the child is of age. However, not all brokers require this.
How Much Can Your Child Contribute
The law stipulates that a minor can contribute either to the full legal maximum of $5,000 per year or up to the amount of income the child earned, whichever is LESS. So, if your child earned $3,100 during the year, she can contribute up to $3,100.
Advantages of Opening a Roth IRA For Your Child
There are many advantages to opening a Roth IRA for your child.
- Educate your child financially. Another personal finance blogger who is also a financial advisor, Jeff at Good Financial Cents, recently addressed a class of soon-to-be graduating college students. Imagine his shock when he learned that none of the students he was addressing had heard of a Roth IRA. These are students who will graduate within months and joining the working world, and they have never heard of a Roth IRA. If you can teach your child early about retirement and the power of compound interest, your child will be in a much better position than most later in his life. Each year, your child will be able to see the Roth IRA balance grow thanks to compounding interest and investment growth.
- Help your child secure her financial future. Consider this—a 20 year old who makes the maximum yearly Roth IRA contribution of $5,000 for one year ONLY “with a 6 percent return compounded annually , will end up with almost $75,000 by age 65—without ever putting in another dime,” according to Reuters. In addition, she is eligible to withdraw up to $10,000 for her first home, penalty-free as well as take distributions to cover qualified education expenses.
- Does not harm your child’s financial aid in college. Many have worried that a Roth IRA opened in your teen’s name would affect the amount of financial aid he may qualify for when he goes to college. However, that concern appears to be unfounded. Mark Kantrowitz of FinAid.org was interviewed for Kiplinger’s and stated, “Retirement account balances – such as in Roth and traditional IRAs, 401(k)s and 403(b)s – aren’t reported as assets on the Free Application for Federal Student Aid (FAFSA), regardless of whether they’re owned by the student or the parent.” The key is to not withdraw any of that money because distributions are counted as income, which can affect your college financial aid eligibility.
Disadvantages to Opening a Roth IRA
Overall, opening a Roth IRA is one of the best things that you can do for your child thanks to the power of compounding interest and time for investment growth.
Consider this—if a child opens a Roth IRA at age 17 and contributes $2,000 a year until she retires at 62 at a 5% return, she will have $335,370 in the Roth IRA although she only contributed $90,000 (State Farm Roth IRA Calculator).
However, this impressive multiplication of money is also the biggest drawback.
When your child is of age, she can do what she wants with the money. Your child will have access to the money, and she could potentially withdraw it and spend it irresponsibly. Of course, once our children are adults, we can only guide them and hope that they have learned about finances and will be responsible.
How to Motivate Your Child to Contribute to a Roth IRA
Many teenagers are only concerned with the present.
If they do work, they often want to spend the money they earn on cars, music, make up, and other immediate purchases.
However, there are a few ways you can help encourage your child to behave responsibly with money.
- Show her the power of compound interest. While Roth IRA calculators can show how the money can grow over the years, 45 years from now is a lifetime for most teenagers. Instead, show them the power of interest in the short term. Let her “invest” her money in the bank of mom and dad for a few months and give her a return of 5%. Let her see how much more money she will have after a few months than if she had spent it. Give her back the money with interest, and she may begin to appreciate compounding interest.
- Match her savings. Much like employers match employees’ retirement savings, for every dollar your child contributes to his Roth IRA, offer to match him. If he contributes $1,000 to his Roth IRA, you submit another $1,000, so he is submitting $2,000 for the year.
- Put the money in the Roth IRA for her. The law stipulates that your child cannot contribute any more than she makes in a year to her Roth IRA. However, the law doesn’t say the child has to be the one contributing. If your child makes $3,000 in a year, you as the parent could put $3,000 into her Roth IRA if you had the money and the inclination, allowing her to use her money to spend, save for college, or another goal.
As a parent, one of the best things you can do for your child’s future is to educate her about finances.
Teaching her about a Roth IRA and the power of compounding interest can change your child’s financial future and put her well ahead of her peer’s on the path to financial security.
Have you opened a Roth IRA for your child? Let us know about it.
This article is part of Roth IRA Movement day, created by Jeff Rose of Good Financial Cents. Be sure to check out the other articles in Roth IRA Movement day (there are over 100 sites taking part).