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Roth IRAs for Kids

Bill Bischoff - SMARTMONEY — 10/21/10

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Plenty of teenage kids work—it’s an American tradition. What isn’t so traditional is the notion of kids contributing to their own Roth IRAs. But if your child works, it should be a tradition.

Roth Contribution Basics

The only requirement for making a Roth contribution is having some earned income for the year. Age is completely irrelevant. So if your child earns some dough (legitimately and on the books), say from a summer job or part-time work after school, he or she is entitled to make a Roth contribution.

Specifically, for the 2010 tax year, your child can contribute the lesser of: (1) the total amount of earned income or (2) $5,000. Although it’s not official yet, the same $5,000 limit will almost certainly apply for 2011 (the $5,000 figure is adjusted for inflation in $500 increments, but there hasn’t been much inflation lately).

These contribution limits apply equally to Roth IRAs and traditional IRAs, but the Roth alternative is the way kids should go in most cases--for reasons I’ll explain below.

How Much Retirement-Age Money Are We Talking About?

By making Roth contributions for just a few years during the teen years, your child can potentially accumulate quite a bit of money by retirement age. I know you don’t want to think about your baby with gray hair, but it’s going happen eventually!

Realistically, however, most kids won’t be willing to contribute the $5,000 maximum to a Roth IRA, even when they have enough earnings to do so. Be satisfied if you can convince your child to contribute at least a meaningful amount each year. Here are some scenarios:

* Say your 15-year-old pays $1,000 into a Roth IRA each year for three years, starting this year. After 45 years (when your “child” is 60 years old), the account would be worth about $39,000--assuming a 6% annual rate of return. If you assume a more-optimistic 8% return, the account would be worth about $89,000.

* Say your child contributes $1,500 for each of the three years. Now the Roth account would be worth $58,500 in 45 years, assuming a 6% return. At 8%, it would be worth about $133,000.

* Bump that up to $2,500 for each of the three years, and the Roth account would be worth $97,500 in 45 years. At 8%, the number jumps to a whopping $222,000.

You get the idea. These are not trivial sums, even though the contribution amounts are modest.

Why the Roth IRA Is Usually the Better IRA Option

First, your child can later withdraw all or part of his Roth contributions--without any federal income tax or penalty--to pay for college or for any other reason. (However, your child generally cannot withdraw Roth earnings tax-free before age 59½.)

Even though contributions can be withdrawn without any adverse federal income tax consequences, the best strategy is to leave as much of the account balance as possible untouched until retirement age. That way, your child could accumulate the amounts mentioned earlier and never owe any federal income tax on the Roth IRA’s earnings.

In contrast, if your child contributes to a traditional IRA, most or all of any subsequent withdrawals will be taxed. Even worse, payouts before age 59½ will be hit with a 10% penalty tax, unless the money is used for certain IRS-approved reasons (one of which is to pay college costs).

What about tax deductions for IRA contributions? Good question. Your child won’t get any for Roth pay-ins, but he or she probably won’t get any meaningful current tax advantage from contributing to a traditional IRA because an unmarried dependent child’s standard deduction will automatically shelter up to $5,700 of earned income (for 2010 and 2011) from federal income tax. Any additional income will almost always be taxed at very low rates. So unless your child has enough income to owe a significant amount of tax (unlikely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly--or entirely--worthless.

The Last Word

Encouraging your working child to make Roth IRA contributions is a great way to introduce the ideas of saving money and investing for the future. Plus there are tax advantages. It’s never too soon for your child to learn about taxes and how to minimize or avoid them. After all, it’s basically a game--and kids love games.


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