Parents with teenage children have many competing financial demands facing them, so opening a retirement account for those kids may not be on their radar.
However, there are compelling reasons to establish a Roth IRA once a teenager is earning some income, and this isn’t just something for affluent families to consider.
People naturally think of IRAs as a way to save for retirement. They are, after all, called Individual Retirement Accounts. But like many parts of the federal tax code, things aren’t always what they seem.
In addition to saving for retirement, Roth IRAs can be used without penalty to help pay for a first home, to pay higher education expenses, and even to pay medical bills that exceed a cost threshold. One key provision is, however, that the account must be open for at least five years to avoid penalties.
So, by opening a Roth IRA for a teenager — the contribution can’t be larger than their earned income that year — you start the five-year clock. Later, depending on their financial circumstances, they will have lots of options they might not have otherwise had.
Establishing a Roth also starts the long-term savings habit for a soon-to-be-adult. That’s crucial, because the earlier they start, the easier it will be to accumulate savings, because of the compounding effect (you earn interest, then you earn interest on the interest earnings, and so on).
In addition to the many ways a Roth IRA account can be used, it also can serve as emergency savings, because contributed funds can be withdrawn without tax or penalty. You don’t get a tax deduction for contributing for a Roth, and you don’t owe tax if you later withdraw the money contributed.
The earnings — interest, dividends, capital gains — are the part of a Roth IRA account that can be subject to tax and penalties if the money is withdrawn before retirement. There are exceptions to the penalty, which is an extra 10 percent tax, in the circumstances I have mentioned.
For a person under 18, a Roth IRA can be opened as a custodial account. Typically, there’s no fee to open an account, but there may be a minimum contribution requirement. Look for accounts with low annual expenses.
Here are some key points to consider:
When it comes to college financial aid, money in a custodial Roth IRA is ignored by federal financial aid calculations. Money in a child’s bank account is not ignored.
Contributions to a custodial IRA can be no larger than the income earned by the minor account owner that year, or $5,500, whichever is lower.
The five-year waiting period that applies to distributions of earnings from a Roth IRA starts the first day of the tax year in which an account is opened. Open an account by April 15, 2016, for example, and the opening date for that account would be Jan. 1, 2015.
Contributed funds can be withdrawn without tax, penalty, or waiting period.
Withdrawals of earnings can be subject to federal income tax plus a 10 percent penalty if the rules aren’t followed. All withdrawals become tax and penalty free at age 591/2 as long as the account’s been open at least five years.
Earnings can be withdrawn without penalty, after the five-year mark, for a number of reasons, including higher education expenses and the purchase of a home. Withdrawals for education expenses can be as large as the full cost “for the year education furnished” but cannot be used to pay off loans. Withdrawals for a home purchase can be up to $10,000. Again, only the earnings portion of the account would be taxed, and the contributions are always withdrawn first.
Leaving the money untouched, for retirement, takes advantage of a long period of compound interest. A 17-year-old who puts $500 in a Roth IRA that averages 6 percent earnings yearly would see that $500 grow to about $10,000 by age 67.
Now, some people would wince at the idea of tapping retirement funds to pay for, well, anything other than retirement. That makes sense, because many people have saved too little or none at all. However, I believe that knowing a Roth IRA can be tapped in times of need can only encourage people to go ahead and start one.
It would likely be a pretty hard sell to persuade a teen to plunk some funds in an account, if they couldn’t touch the money for 50 years, or to persuade a parent to start funding their teen’s retirement.
It’s a different story when it’s clear those contributions could be withdrawn if needed, and even the earnings could be tapped without penalty to help buy a home.