If your child’s first summer job is “in the books”, right now is a great time to help them evaluate saving for their future. One long-term saving vehicle to consider is a Roth IRA. Explore the details of contributing to a Roth IRA and evaluate whether it aligns with your family’s savings priorities.
Learning Points
Transforming a Summer Job Into a Lifetime Habit of Purposeful Saving
With summer officially coming to an end, your child’s summer job could provide them with an opportunity to start saving for retirement this year. You probably remember your first few, real summer jobs. Maybe you mowed lawns, painted, or caddied. Perhaps you worked in the food service, leisure, or hospitality industries or tried your hand at retail.
Whatever you were doing, those first paychecks likely created an amazing feeling of possibility and independence. Most kids will have little trouble spending their paycheck money and enjoying the present. However, those paychecks do not come with instructions on how to thoughtfully save or invest for the future.
You can help your child channel their new energy and hard-earned income into an intentional, life-long habit of saving. Even though retirement is probably one of the last things on your child’s mind, let’s explore what it means to invest in a Roth IRA.
Evaluating Your Child’s Roth IRA: Did Your Child Earn Compensation?
Specifically, if your child has earned income for a summer job, evaluate whether opening and funding a Roth IRA aligns with your family’s savings priorities. Generally, their earned income would have come from compensation they earned from working. For example, if they received hourly wages, tips, bonuses, or commissions, those would be good examples of compensation.
So, if they worked at a summer horse camp as a counselor and were paid hourly, that would be considered compensation. Things like interest income and dividend income would not be viewed as compensation. Certain gigs that don’t require taxes to be withheld, like part-time babysitting, might cause your child to not have earned income.
The details do matter, and personalizing a decision often means working with your team of professionals. If you, or a loved one, have a goal of helping fund your child’s retirement account, or creating additional financial flexibility for them later in life, a Roth IRA is worth researching further.
With that in mind, let’s dive into some of the essential details and considerations of a Roth IRA.
What Is an IRA?
If this is your child’s first experience with retirement planning and investing, it can be helpful to start at the beginning.
An Individual Retirement Account (IRA) is a tax-advantaged personal savings account generally used for setting money aside for retirement. Depending on the type of IRA and your personal circumstances, these tax advantages can include tax-deductible contributions for traditional IRAs and tax-free withdrawals for Roth IRAs.
Because topics like funding a child’s Roth IRA, like so many others in financial planning, intersect with the world of tax, make sure you coordinate with a qualified tax professional.
A Roth IRA can be a great way to teach your child the basics of investing and getting an early start on retirement saving.
Common Types of IRAs
Your child’s Roth IRA offers different benefits and considerations.
Let’s break down how Roth IRAs work, provide some educational information, and make Roth IRAs more approachable.
Roth IRA: Contribution and Income Limitations
Your child can open and contribute to a Roth IRA if they received taxable compensation during the year. Your child’s Roth IRA contributions consist of after-tax dollars – money they’ve already paid income tax on.
In 2024, taxpayers can contribute up to the following amounts into a Roth IRA:
- $7,000 per person.
- Up to $8,000 per person if you are age 50 or older.
There are no age limits on making regular contributions to traditional IRAs or Roth IRAs (those rules ended after 2019). These IRA contribution limits are per taxpayer, not per account. So, if you have both a Roth IRA and a traditional IRA, you aggregate your contributions across both accounts up to the applicable limit.
In 2024, there are adjusted gross income phase-out ranges for taxpayers making contributions to a Roth IRA.
- For single and head of household taxpayers, the income phase out is between $146,000 and $161,000.
- For married couples filing jointly, the income phase-out range is between $230,000 and $240,000.
While it’s unlikely the average summer job is going to exceed these limits, it’s important to know the rules.
A Common Question: Could I Give Money to My Child to Fund Their Roth IRA?
Yes. If you plan to help fund your child’s Roth IRA, you’ll want to follow that year’s annual gift exclusion rules. Your child would still need to adhere to the applicable Roth IRA contribution limits.
The Potential for Tax-Free Growth
Unlike a traditional IRA, your child’s Roth IRA contributions consist of after-tax dollars – money they’ve already paid income tax on. This allows your child’s Roth IRA contributions to grow tax-free provided that you follow the IRS’ Roth IRA rules.
Roth IRA: Tax Deductibility
There is no tax deduction currently for Roth IRA contributions.
For many American families with children who are only working part-time, those children are generally in the lower tax brackets. And so, the potential for them to deduct their traditional IRA contributions is relatively infrequent.
Whether you want to contribute to your child’s Roth IRA or traditional IRA will depending on your goals and individual circumstances.
Roth IRA: Withdrawal Sequence and Qualified Distributions
When you or your child invests in a Roth IRA, there are specific withdrawal rules to consider.
Roth IRA withdrawal rules are relatively more flexible than those for traditional IRA or 401(k) plans.
When you need to access your Roth IRA funds, the order of withdrawals is as follows:
- Contributions (1st)
- Conversions (2nd)
- Earnings (3rd)
Looking ahead, if you think your child might need to use their Roth IRA funds before hitting retirement age, like to help pay for school or a first home, keep the following withdrawal sequence in mind.
If your child experiences an unexpected expense that fully depletes their emergency fund, you can distribute some or all the principal contributions from your child’s Roth IRA at any age for any reason without taxes or penalties.
The downside to withdrawing retirement assets from your child’s Roth IRA before their retirement, at a minimum, is that it takes them further from their retirement goals.
Keep in mind that there is a five-year holding period for qualified distributions. This period begins January 1 of the year a contribution is made to any Roth IRA.
And so, starting that holding period sooner can create additional flexibility. It should not be the primary driver for funding your child’s Roth IRA, though.
You can read a current summary of early withdrawal penalty exceptions for IRA accounts here.
Your Child’s Roth IRA: What Are Your Investment Goals?
If your child does open a Roth IRA, you’ll also want to consider how the contributions will be invested. Many long-term investors are seeking a sense of security when they create a financial plan and choose to invest. While peace of mind is relative for each of us, you can demonstrate to your child that thoughtful dialogue and planning can create more flexibility later in life.
You can also help your child focus on what they can control, and to pair long-term goals, like retirement, with a personalized, long-term investment strategy. Like a workplace retirement account, your child’s Roth IRA can provide investment flexibility. Your child’s Roth IRA investment options are broader relative to a typical 401(k) plan.
With your child’s Roth IRA, you can select what you invest in, as well as how much and when you invest. Mutual Funds, exchange traded funds (ETFs), and bonds are all potential investment options to consider for your child’s Roth IRA. IRAs cannot invest in life insurance or collectibles, such as art, antiques, gems, coins, or alcoholic beverages. IRAs can invest in certain precious metals only if they meet specific requirements.
Long-term investors like you recognize that after-tax returns matter. Investors can look to minimize the effects of taxes on investment returns by placing different types of investments in tax-advantaged accounts or taxable accounts based on the tax treatment of the account and their personal circumstances. Roth IRAs are tax-free accounts, and long-term investors generally see better tax-efficiency by holding equities – like mutual funds and exchange traded funds (ETFs) – in these types of accounts.
Asset location is a broader lens that you can apply to all your investment accounts. It’s something that needs to be personalized to fit your specific facts and circumstances. If you’re looking to learn more about how asset location and asset allocation can provide a tax-aware framework, and where your child’s Roth IRA might fit into the mix, here’s a good read on asset location and asset allocation.
Creating Teachable Moments
When you’re chatting with your child about saving and spending, you have the opportunity to look beyond the numbers immediately in front of them.
You can teach your children about the power of compounding, the nuances of delayed gratification, and long-term decision making. Starting the conversation early can help your child become familiar with saving and investing. Your child’s Roth IRA is just one of many investment accounts to consider, and the right choice will depend on your personal goals and circumstances.
You can share your own investing journey and help the next generation feel more comfortable evaluating their saving and investing options.
It could inspire them to proactively learn more, ask questions, and seek out new information that better prepares them for the future.
The Next Step
When you know who and what are truly important, you can create incredible clarity about your spending and saving.
Clarity to confidently spend on things that matter. Clarity to avoid spending your hard-earned resources on things that aren’t aligned with what you want in life.
As your financial planner in Saint Louis, we can help you plan for the future and enjoy the present moment.
Start feeling more confident that you are making progress toward your savings priorities. Understand whether funding your child’s Roth IRA aligns with your goals and values.
Proactive and open collaboration with your financial, tax, and estate planning professionals can help you work towards your financial goals. Working with your financial planner in Saint Louis can provide you with the right mix of accountability, collaboration, and long-term thinking.
If you’re unsure about your next step, let’s talk.
Disclosure
This commentary is provided for educational and informational purposes only and should not be construed as investment, tax, or legal advice. The information contained herein has been obtained from sources deemed reliable but is not guaranteed and may become outdated or otherwise superseded without notice. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decision.