Ariel Skelley | digitalvision | Getty Images
How would it feel to give your children an enormous leg up on saving for retirement while also helping them form healthy money habits?
The answer could be opening a Roth individual retirement account for them.
To start, a Roth IRA is a special retirement account that allows participants to receive tax-free income in retirement. There are no age restrictions; therefore, a child can have a Roth IRA account and get a great head start on both their retirement savings and wealth-building goals.
It is important to know that a child must have some earned income to contribute to a Roth IRA, but anyone can also contribute on behalf of an eligible child.
The IRS will consider earnings from a part-time afterschool job or summer working experience as eligible to be invested in a Roth IRA. However, savvy business owners might also hire their children to help with filing, cleaning or other tasks that allow the owner to help their child get this huge leg up on retirement savings.
Here’s how Roth IRAs work
When your child adds cash to their Roth IRA account, they do not get any tax breaks — which would not be valuable to them, in any case, as children’s tax rates are typically very low. However, the valuable tax benefits come on the back end.
Your child will be able to withdraw their contributions and earnings 100% tax-free once they are over age 59½ (based on current rules). Both the investment made and all the interest, dividends and growth on these assets escape the clutches of Uncle Sam and will accumulate a nice pot of cash over time.
If your child needs access to the investment account sooner, they can withdraw their contributions tax- and penalty-free for any purpose, if they have owned the account for at least five years.
Why Roth IRAs are ideal for kids
Children have decades for their Roth IRA contributions to grow, tax-free. The power of compounding works by exponentially increasing the account’s value. First, all profit earned will be added back to the principal amount, and then reinvested in the stock market to accelerate account growth.
A famous polymath, inventor, scientist and diplomat also praised the power of compounding during his life. Benjamin Franklin commented: “Money makes money. And the money that money makes, makes money.” Franklin’s definition of compounding is spot on and why saving as much as you can at a young age is powerful.
The Rule of 72
While compounding may sound complicated, especially if you don’t have spreadsheet software, you can use a formula to do these calculations in your head. The Rule of 72 is a helpful method to figure out how long it will take to double your cash.
To determine the amount of time to double your investment, divide 72 by the interest rate. For example, if your child invests in the S&P 500 Index and it returns 10% over time, they will double their investment value in the portfolio in 7.2 years (72 divided by 10).
Even Albert Einstein was impressed by this math. There is an often-told story that when asked what mankind’s greatest invention was, he said: “The most powerful force in the Universe is compound interest.” He referred to saving money and having it grow as one of the greatest “miracles” known to man.
How to open an IRA for a child
Opening a Roth IRA for your child is pretty simple.
Schwab, Fidelity, E*Trade and many other firms offer custodial Roth IRA accounts for your kids. As the custodian on the account, you will control the funds in the IRA, making all investment decisions until your child reaches majority age.
In most states, the age of majority is 18, and others have higher ages of 19 or 21. Once your son or daughter reaches majority age as defined by your state, the Roth IRA transfers to their name, solely.
How to fund a Roth IRA
A child of any age can save in a Roth IRA. However, the work your child engages in should be age-appropriate with “reasonable wages.” Knowing what is earned income is very easy with a job working for a company that will issue 1099s to your child at the end of the year.
However, the line can get blurry when your child is working for you, babysitting, lawn mowing or setting up their own business, such as a lemonade stand. Accountants agree that keeping good records and invoices for work performed is critical.
Parents can also help their child supercharge their Roth IRA savings by matching the contributions.
For example, if your child makes $2,000 at their local ice cream shop over the summer and saves half of this in their Roth IRA, parents can add up to $1,000 more to the investment account. The only hitch is that your combined contribution must not exceed your child’s earned income for the year. Also, note that there is a maximum IRA contribution limit of $6,000 for 2022.
Building good financial habits
In addition to creating a well-padded retirement fund, your child will start developing healthy financial behaviors from a young age. Studies show that the earlier children learn about money and how it works, the better off, financially, they will be long-term.
Unfortunately, you cannot rely on your local school to teach even the basics of good money habits. Very few states mandate personal finance classes, and even fewer have qualified professionals teaching the material.
Saving into a custodial Roth IRA with your child is the best way to ensure that they will be financially secure and develop a genuine regard for the value of their money, today and in the future.
The bottom line is that Roth IRAs are ideal for kids, because children have decades for their contributions to grow tax-free.
— By Stacy Francis, president and CEO of Francis Financial