As your teen begins to earn money from a job, it’s a great time to teach them about saving for the future. While a savings account is a great start, an even better opportunity is for your teen to open an IRA. With an IRA, your child can invest their hard-earned funds and grow their savings in a tax-advantaged account.
There are two types of IRA accounts – a Roth IRA and a traditional IRA.
Contributions to a Roth IRA are made post-tax, but withdrawals are generally made tax-free. Contributions to a Roth IRA can be withdrawn at any time without penalty; however, you must wait until age 59½ to withdraw any earnings or face an early withdrawal penalty. There are exceptions to the penalty, such as using a distribution for a first-time home purchase.
Contributions to a traditional IRA are made pre-tax, but withdrawals are taxed as ordinary income. Contributions decrease your current taxable income, and the funds grow tax-deferred. The deduction provides an immediate benefit to account holders with taxable income, but all withdrawals are taxable regardless of whether it was a contribution or earning.
In general, a Roth IRA makes more sense when you expect to be in a higher tax bracket at the time of withdrawal. Conversely, a traditional IRA may make more sense if you expect to be in a lower tax bracket in the future. Most young adults expect to be in a higher tax bracket in the future.
If your teen has a job and beginning to earn money, then now may be a great time to set up a Roth IRA. The standard deduction is $12,950, so unless your child earns more than the standard deduction, their income should be free of federal income tax. Therefore, setting up and investing in a Roth IRA would make the most sense since the deductions provided by a traditional IRA would be of little use.
If your child earns more than the standard deduction amount of $12,950, contributions to a traditional IRA could decrease their taxable income, reducing if not eliminating their tax liability. But even if their earnings exceed the standard deduction, they are probably in a lower tax bracket now as a young adult than when they retire, which favors a Roth IRA. Additionally, the ability to withdraw contributions without penalty at any time is a significant advantage of a Roth IRA over a traditional IRA for a young person.
An IRA account holder may invest up to the lesser of $6,000 or their total earned income for the year. Parents may face the reality that their child is unwilling to invest some or all of their hard-earned money in an IRA. Parents may consider gifting funds to a child for investment in their IRA. A parent can gift up to $16,000 to a child each year tax-free. Thus, if a child earns $5,000 over the summer, a parent could gift the child $5,000 to be invested in their IRA. A parent could also encourage their child to invest in the IRA by matching the child’s contributions, in which case a parent might gift $2,500 to match the child’s $2,500 contribution. Regardless, if the child earns $5,000 for the year, no more than $5,000 may be contributed to the IRA.
Children under age 18 (21 in some states) will need a custodial guardian, usually a parent, to open an IRA account. A custodial guardian manages the account for the child’s benefit until they reach legal age. Setting up an account is easy, and there is typically no minimum investment amount required for opening an account.
This article provides a brief overview of how a child might benefit from investing in a Roth IRA and is not a substitute for speaking with one of our expert advisors. If you have questions about setting up a Roth IRA for your child or want to discuss estate planning, please contact our office. A member of our tax department would be happy to discuss your unique situation.