Linda Rogers' father set her up for retirement when she was just a teenager. Her summer pay from waitressing was hers to keep, as long as she deposited the first $500 into a Roth IRA at the local credit union.
"It was non-negotiable," said Rogers, now 35 and a certified financial planner in San Diego. "I knew that the first $500 went in there, and I could have the rest."
Anyone, regardless of age, can contribute post-tax earned income to a Roth IRA, which grows tax-free. Withdrawals are allowed after five years, penalty and tax-free, making a Roth IRA the account of choice for a teenager's summer earnings, according to financial planners.
The alternatives hardly stack up. Savings accounts earn a pittance at today's interest rates, and kids get to control the money after they turn 18, which can be risky if they are not responsible. Brokerage accounts kick off taxable interest every year. Since colleges count both kinds of accounts as assets, this could reduce the amount of financial aid available to prospective students. Regular IRAs, which take pretax earnings, offer no tax advantage to young people with low earnings.
"Most folks aren't thinking about retirement for their kids. They are thinking about buying them a car," said Edward Vargo, a certified financial planner in Westlake, Ohio. Vargo prepped his oldest daughter, 18, years ago by showing her the magic of compound interest using an online calculator (investor.gov). Without letting her know, he seeded her Roth IRA with $1,000 that she earned doing office work for him at 16.
Last summer, when Vargo's daughter got a paycheck for a hospital internship, he wanted her to contribute 20 percent of the $1,500. Assuming a reasonable 8 percent long-term growth rate, she will end up with $219,032.66 in 50 years by contributing just $300 a year. The math hooked her in. This summer, Vargo's daughter earned more at her summer job and will contribute $1,000.
Taxing Effort
One step that keeps people from contributing to a Roth for their kids is that it requires filing a tax return. For low-earning kids with odd jobs like delivering newspapers or mowing lawns, it might not seem worthwhile.
The IRS does not require a return for dependent children earning less than $6,300. For a babysitter with a steady client, it might even cause a headache for an employer who is not paying employment taxes, noted David Demming, a certified financial planner in Aurora, Ohio.
But the typical teen earning a few hundred bucks will likely not have to pay anything to the IRS. Putting a kid on the payroll can reap even more tax benefits for families with a small business or who are self-employed, said Demming. Many of Demming's clients offer a matching incentive.