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Roth IRA for a teenager - Astronomical Result Thumbnail

Roth IRA for a teenager - Astronomical Result

Funding a Roth IRA for teenage children can be a great way to give them a head start on building wealth for their future. However, there are some key points to consider:

1. **Earned Income Requirement:**

   - To contribute to a Roth IRA, an individual must have earned income. This includes income from a job, such as wages or self-employment income.

   - If your teenager has a part-time job or earns income through self-employment, they can use that income to fund a Roth IRA.

2. **Contribution Limits:**

   -The annual contribution limit for a Roth IRA is the lesser of the individual's earned income or the annual limit set by the IRS.  The 2023 amount is $6,500.

 3. **Parental Involvement:**

   - Since minors cannot open brokerage accounts on their own, a parent or legal guardian would need to open a custodial Roth IRA on behalf of the teenager.

   - The custodian maintains control of the account until the child reaches the age of majority, usually 18 or 21, depending on the state.

4. **Investment Options:**

   - The funds within the Roth IRA can be invested in various ways, such as stocks, bonds, or mutual funds.

   - It's advisable to choose investments based on the individual's risk tolerance, financial goals, and time horizon.

5. **Long-Term Growth:**

   - The advantage of a Roth IRA is that qualified withdrawals, including earnings, are tax-free. This can provide significant long-term growth potential for the contributions.

6. **Educational Opportunities:**

   - Using a Roth IRA for educational expenses is allowed without the usual early withdrawal penalties, but it's important to check the specific rules and consult with a tax professional.

7. **Teaching Financial Responsibility:**

   - Involving teenagers in the process can be an excellent opportunity to teach financial responsibility, budgeting, and the importance of saving for the future.

Andy Ives from Ed Slott's team wrote a fantastic piece on funding your teenager's Roth IRA.  It's one of my legacy strategies I share with all of my clients. I'm sharing it on my blog because his rendition of the impact of saving in a Roth and letting compounding of growth or time do all of the work makes a compelling argument. 

By Andy Ives, CFP®, AIF®IRA Analyst @theslottreport

" The mailman delivered my son’s 2023 W-2 the other day. I was curious what he earned last year as a lifeguard at our community pool, so I opened the envelope. Box 1, “Wages, tips, other compensation” said $4,500. Not too bad for a teenager working a summer job – especially since he never spends a dime. (While past performance is not indicative of future returns, I can’t imagine ever needing to establish a trust with a spendthrift clause to protect the kid from himself. He throws around nickels like manhole covers.)

Regardless of his frugality, the point of my W-2 interest was to see how much he could contribute to a Roth IRA. He is light years away from the Roth IRA income phaseout levels, so no concerns there. In 2023, the married/filing joint phaseout was $218,000 - $228,000 and $138,000 - $153,000 for single filers. (For 2024, those numbers jump to $230,000 - $240,000 and $146,000 - $161,000, respectively.)

 While the maximum Roth IRA contribution amount for 2023 was $6,500 (or $7,500 for anyone age 50 or older), a person cannot contribute more than what he earned. So, the most my son could contribute to a Roth IRA as a prior-year contribution is what was listed in Box 1 on his W-2: $4,500. What if he mowed lawns all summer and made $4,500 “under the table”? Unless he claimed those dollars as taxable income, they would not qualify for an IRA contribution.

 As for the task of funding the Roth IRA - does it matter where the $4,500 comes from? It does not. The IRS does not care if I fund my son’s Roth IRA for him, or if a grandparent funds his Roth IRA, or if a rich neighbor gives him $4,500 for the contribution. The IRS is only concerned about my son not exceeding what was reported in Box 1 on his W-2. If a grandparent or a rich neighbor were to make the $4,500 contribution, no special tax reporting is necessary. Cash gifts, each up to the 2024 gift tax cap of $18,000, can be made to an infinite amount of people, related or not, and no special forms are required.

 To summarize, he had taxable compensation of $4,500 in 2023. His Roth IRA contribution for that amount (coupled with his existing account dollars), brought his total Roth IRA balance up to an even $10,000. The Roth IRA is invested in quality mutual funds with a more aggressive tilt. With a few clicks on a financial calculator, the powers of compounding (or what Albert Einstein called “the 8th wonder of the world”), are revealed.

 Assuming not a single additional penny is ever contributed to his $10,000 Roth IRA:

  • $10,000 at 6% annual growth after 40 years? $102,857
  • $10,000 at 8% annual growth after 40 years? $217,245

 What if he contributed just $5,000 each year for the next decade, but then stopped contributing for the remaining 30 years?

  • $10,000 now, plus $5,000 for 10 years, at 6%, after 40 years? $481,373
  • $10,000 now, plus $5,000 for 10 years, at 8%, after 40 years? $946,111

 If you have the means, a little can become a lot. It’s not about timING the market, it’s about time IN the market. If a teenager starts early, the long-term benefits could be astronomical."

Before taking any specific actions, please reach out to me so that we can review your individual circumstances and the most recent tax regulations. Additionally, tax laws can change, so staying informed about any updates is crucial.