Your child will thank you later.
Opening an individual retirement account (IRA) might not be top of mind this year, but if your child landed a summer job, it's something to consider. A Roth IRA is a retirement account where contributions are made with after-tax dollars now in exchange for tax-free dollars during retirement. Since most children are in a lower tax bracket, a Roth IRA makes sense for tax purposes.
If you're on the fence about opening a Roth IRA, we've jotted down three reasons why it might be one of the best moves you can make for your child's long-term success.
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1. Teach financial responsibility
Since Roth IRAs don't have age limits, you can open a Roth IRA for your child and provide them with a hands-on financial education. To do this, you'll need to open a custodial Roth IRA and manage the account on your child's behalf until they are old enough to take over. This setup allows you to teach your child how to save and set financial goals, which can come in handy when they become an adult and have to manage their money on their own.
For example, let's say your child earns $8,000 from their summer job and other work opportunities during the year. Since the Roth IRA contribution limit for 2024 is $7,000 for those under 50, you can set savings goals with your child to get them involved in the process and help them contribute as much as possible.
You might agree to match whatever your child contributes to the account. So if your child contributes $3,500 to their Roth IRA and you contribute another $3,500, they will be able to max out their Roth IRA contribution. This is an excellent opportunity to show your child how to save money from each paycheck, so they can contribute $3,500 to the account. By involving them in the process, they'll have a stake in their financial future and be less likely to dwindle the money away when they take control of the account.
2. Tap into the power of compound growth
One of the biggest perks of opening a Roth IRA for your child is the power of compound growth. In a nutshell, compounding is the process whereby earnings on investments generate their own earnings over time. So your interest helps you to earn more interest, and your dividends are producing more dividends. The power of compounding is what makes it possible to build a million-dollar Roth IRA over time, even though the contribution limits are lower compared to other retirement accounts.
Take a look below at how much your child could earn over time if they consistently contribute $7,000 to a Roth IRA every year and average an 8% investment return annually. Since contribution limits increase over time, your child will have a better shot at reaching a million dollars sooner if they aim to max out their account each year. After your child reaches age 59 1/2, all of the money in the Roth IRA will be tax-free, thanks to the tax perks of the account.
Growing at 8% for | $7,000 Invested Annually |
|---|---|
10 years | $109,518 |
20 years | $345,960 |
30 years | $856,421 |
40 years | $1,958,467 |
Do your research before you start
Although there are many reasons to consider opening a Roth IRA for your child, it's best to weigh the pros and cons before you get started. For example, you cannot contribute to a Roth IRA for your child if they don't have earned income for the year. Certain forms of income, such as dividends and interest, don't count as earned income.
While earning the average historical rate of return of around 10% or higher would be ideal, investment returns are not guaranteed and can fluctuate based on market conditions. Make sure you do your research before selecting investments for your portfolio.
Also, you'll have to make sure your child's income doesn't exceed the annual Roth IRA threshold, which usually isn't an issue for children. However, if your child doesn't earn at least the maximum contribution amount for the year, which is $7,000 in 2024, their contribution would be limited to their earned income for the year.
There are a few things you should consider before getting started. Talk to a professional to make the process easier. If it makes sense for you to open and contribute to a Roth IRA this year, it could be your child's golden ticket to a tax-free million-dollar retirement account.
