Last Updated on January 16, 2020
IRA Financial’s Adam Bergman discusses why you should open a Roth IRA for your kids, how it works and the benefits of the plan.
In his latest podcast, Mr. Bergman talks about the importance of setting up a Roth IRA for your kids. Furthermore, he discusses the major benefits of the plan and how you can start one for your child. He also talks about how your child can fund the account. Finally, he will illustrate how much you can save in a Roth IRA versus a taxable account. It’s important to educate your kids about financial responsibility.
What is a Roth IRA?
A Roth IRA is a tax-advantaged retirement plan that anyone can open and fund so long as he or she has earned income for the year. The major benefit of the plan is that all qualified withdrawals from the plan are tax-free. Unlike a traditional plan, there is no upfront tax-break. Roth IRAs are funded with after-tax money. However, so long as the account has been open for at least five years and you are at least age 59 1/2, your distributions will be tax-free. Traditional plans are tax-deferred, which means you pay taxes on your withdrawals.
Another benefit of the Roth is there are never any requirements to withdraw from the plan. With a traditional IRA, you must start distributing funds from the account once you reach age 72. There are no such requirements for a Roth IRA. If you don’t need the money, you can pass on the entirety of the account to your beneficiary.
Thanks to the power of compounding, the eighth wonder of the world according to Einstein, your bottom line will continue to grow year after year. As an example, if you put $1,000 in your Roth IRA when you are 15 years old and never touch it again and earn 10% every year until you are age 70, you would have $189,000 in the account. Even if your investments only earned 7%, you would still amass over $41,000. Just think how much you would have if you contributed $1,000 every year starting at age 15?! That’s the power of compounding. That’s the number one reason your kids need a Roth IRA!
How Can You Start a Roth IRA for Your Kids?
Essentially, your son or daughter needs to have earned income to be able to contribute to an IRA. Obviously, most kids that age don’t have a 9-5 job yet. That doesn’t mean they cannot open a Roth IRA. They just need income from performing bona fide service. If you pay your kids an allowance for doing chores, such as taking out the garbage or mowing the lawn, that does not count.
If you have your own business however, you can pay your child a reasonable salary for the work that he or she performs. Basically, they can’t be treated differently just because they are your children. Essentially, they have to earn what they make. You can’t pay them $50/hour to wait tables or make deliveries.
If you don’t have a business that can hire your child, they would need to go out on their own to make money. While it doesn’t count if you pay your son to shovel the driveway, it’s perfectly acceptable if your neighbor pays him. Again, it must be a reasonable earning.
In short, so long as your child performs a bona fide service, either for a business you own, or for someone else, and is paid a reasonable amount of money, that money is considered earned income. Therefore, you can start a Roth IRA for your kids.
Starting a Roth IRA for your kids is one of the best ways to teach them about finances and saving for the future. The unique benefit of compounding PLUS tax-free withdrawals can show them how starting young and putting aside as much as possible can lead to real wealth. You can use our Roth IRA calculator to plug in your own numbers and see how much your money can grow.
As always, thanks for listening to our podcast. Please check out all of our podcasts on our SoundCloud page for all things retirement-related.