What if your child could invest tax-free money today, and in 40-50 years take the proceeds out tax-free? Would you be interested? Almost anyone who receives compensation can open up a Roth IRA account.
There are two main types of individual retirement accounts, the traditional IRA and the Roth IRA. Traditional IRA’s allow for tax deductions for current year contributions. When distributed, the original contributions, along with any earnings, are then fully taxable. The Roth IRA allows for your contributions and earnings to accumulate tax-free. No tax deduction is allowed for contributions, unlike the traditional IRA, but you never have to pay taxes on qualified distributions.
IRS guidelines permit people to contribute up to $5,000 to their IRA/ Roth IRA, or up to 100% of compensation, whichever is less. Although there are no minimum age requirements to open a Roth IRA, there are two conditions that you need to be aware of. First, if your child is under the age of majority they are not legally able to open an account. This means that the parent must act as the custodian of the account until your child reaches legal age. Secondly, your child must have earned income and it must at least equal the amount of contributions for the year. If you were to pay your child $20 each week to mow the lawn/shovel snow and $15 to clean the house and take out the garbage then your child has already earned $1,820 for the year.
One of the best benefits of this plan is that your child has earned income but doesn’t have to pay any federal or state income taxes. This means that they don’t need the tax deduction associated with a traditional IRA. An added bonus is that kids can keep their earnings and parents, or even grandparents, could contribute to the funding of the Roth IRA.
Assuming your child was able to invest $1,800 each year from age 10 through the age of 18 and average 8% annual return, his retirement account would be roughly $23,000 at age eighteen. That amount increases to $500,000 if they were able to invest that amount annually until age 50. If investing tax-free money and withdrawing tax-free money for your child’s retirement wasn’t enough, another great reason for you to open a Roth IRA for your child is that they can use part of the funds for college or the purchase of their first home. The IRS allows for tax and penalty free distributions of your contributions for the funding of qualified higher education expenses (tuition, fees, books, supplies and equipment). If distributions are in excess of cumulative contributions, the earnings, would be taxed at your child’s tax rate for that year, but would still be exempt from the 10% penalty.
There is no limit to the amount that can be withdrawn for qualified education and whether it’s entirely tax free or not, they never have to repay any of the distributions. Your child could also use the Roth IRA funds to purchase or build their first home. Assuming that they have had the Roth IRA for five years, your child can take a distribution of up to $10,000 tax and penalty free. That’s regardless of how much of the distribution was contributions or earnings. Again, this amount does not need to be repaid, EVER!
We suggest opening a Roth IRA as soon as possible, making the minimum contribution, and contribute more as circumstances permit. As the above example showed, it’s clearly better to invest even the smallest amount early on, as the rewards for your child are staggering.
