A Roth IRA for Kids . . . You Bet!

Last weekend, we had family movie night at the Cutter household. With teenage girls in the house, it’s not often that we’re all home together on a Saturday night, so I gave up control of the remote to Phoebe and Sophie for the evening. Well . . . for most of the evening, until the fighting began on who had more time holding the remote. Anyway, during a popcorn break, I scrolled through the channels until I landed on an old TV game show called “Who Wants to Be a Millionaire?”

Remember the show? It was the one where contestants answer a series of questions in a quest to win the million-dollar prize. I used to love this show – it was on for years and had a slew of funny celebrities as hosts. The girls joked about how easy the questions were and how, if they were contestants, they’d walk away with a cool million bucks in one episode. I agreed that the million dollars would be a great start to their retirement plan, and I got the typical teenager response – “Uh-huh, dad, sure”, accompanied by the teenage girl eye roll.

Hmmm . . . I got thinking.

I got thinking about my friend, let’s call him John. John is a junior at Falmouth High School. John is a very smart and determined young man. He reads this column each week religiously and his desire is to be a millionaire early in life. This kid is on his way. He has saved over $6,000 in his two summers of working. He and his mom stopped in last week with his summer earnings to be put to good use.

I ran through a scenario with John – if a 16-year old put away $6,000 in an account earning roughly 8%, added the equivalent of $3,000 of summer earnings each year, and didn’t touch it until age 55, my buddy John will have about a million bucks! He got it. By breaking down the calculation, he and his mom quickly saw how the power of discipline and compound growth over 40 or more years.

I also showed him a scenario that if he waits to age 30, assuming all assumptions are the same, instead of $3,000 per year savings, he would have to beef that up to over $12,000 per year to accomplish the same goal.

Now, I realize it’s not easy for kids to think about saving for retirement when they haven’t even started to work full time. It’s just not a priority for most kids in their teens to put money away for a retirement that’s decades away. But what if the money your teen earned babysitting or dog-walking were invested over the long-haul?

Folks, ask any qualified retirement specialist when to start saving for retirement, and they’ll say, “Start Now”. The Oregon State Treasurer Tobias Read agrees. In fact, he is even pushing Congress to lower the minimum age for IRAs contributions to age 16 (Oregon’s minimum age to open an IRA is 18; different states have different minimum ages). He has stated, “…we sure like the idea of getting them in the habit of saving from the beginning of their career.”

And you know . . . so do I. Now, assuming we can convince a teenager to part with some of his or her hard-earned money like John, what options do they have to get a jump start on retirement?

One of the more popular options for retirement savings, the 401k, is usually not an option for a student who is just a part-time worker, as benefits are generally reserved for full-time employees. However, a Roth IRA can be a great savings option for kids and teens to consider. This week let’s take a look at the Roth IRA and some of the benefits it offers the younger investor.

For starters, contributions can be withdrawn at any time. In general, retirement accounts are pretty restrictive when it comes to taking distributions; many charge a 10% tax penalty on money taken out before age 59½, in addition to income taxes. That’s tough on kids, who aren’t exactly known for their ability to delay gratification.

But a Roth IRA is different. The money contributed to the account can be withdrawn at any time and used for anything from an iPhone, a car repair, or even paying for college. Withdrawals from IRAs, including Roth IRAs, are actually exempt from withdrawal penalties if the funds are used specifically for qualified educational expenses, including tuition, fees, books and room and board.

The rules are stricter for the Roth IRA’s earnings, or the return on contributions that are invested. Distributions of investment earnings may be taxed as ordinary income, penalized with a 10% early distribution tax or both.

More time also means more growth opportunity. Albert Einstein, one of the smartest guys of the 20th century, called compound interest the 8th wonder of the world. Given time, invested money earns more money. The average adult may have 30 or 40 years until retirement once we start investing; a kid who starts earlier has the benefit of much more. If your kids leave their money in the Roth IRA until retirement, they could be looking at 50 or more years of investment growth, completely tax-free.

Long term investing beats saving. A Roth IRA allows your kids to pick and choose investments, which, over the long term, can lead to significant growth. Savings accounts at a bank, by contrast, pay a relatively flat interest rate that currently hovers around 0.09%. That’s a far cry — and many thousands of dollars — from what you could earn annually from a long-term investment. Even at a 1% interest rate — paid by many online savings accounts today — a one-time deposit of $6,000 won’t even double after over 70 years. Even my friend John would be in his twilight years.

There are trade-offs, of course: Most notably, market risk. As with any market-based investment, your kids could lose the money they invest in a Roth IRA, though history tells us that’s unlikely to happen if they have a solid investment strategy and stick to a diversified portfolio over a long period of time.

Also, while there is no age limit, the child does need to have earned income. Earned income is defined by the IRS as taxable income and wages — money earned from a W-2 job, or from self-employment gigs like baby-sitting or dog walking. (If as a parent you want to contribute to your child’s Roth IRA or match your child’s contributions, that’s fine as long as she has at least as much earned income as the total contribution amount).

There are contribution limits, too. The Roth IRA contribution limit is $6,000 a year in 2019, or the total of earned income for the year, whichever is less. If a child earns $2,000 in 2019, he or she can contribute up to $2,000 to a Roth IRA.

When it comes to opening the account, a parent needs to help. While your child’s income makes him or her eligible for a Roth IRA, a parent or other adult will have to help them actually open the account. Roth IRA providers typically require an adult to open and manage a custodial Roth IRA on behalf of a minor.

Clearly, the young have a huge advantage when it comes to building wealth for retirement because they have the gift of time to maximize the power of compound interest. With compounding, they can save a little now and reap big rewards later. So, in your quest to raise a future millionaire: Be vigilant and stay alert, because you deserve more!

Have a great week.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield & Southlake, TX. Jeff can be reached at jeff@cutterfinancialgroup.com.

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