Opening a Roth IRA for your kids is a must once they start generating earned income. Not only will opening a Roth IRA help build wealth for your kids, if you have a business, it will also help you save on taxes.
If you start contributing to your kid's Roth IRA young enough, there's a good chance their Roth IRA could be worth over $100,000 by the time they turn 18! If you combine their Roth IRA with a custodial investment account and a 529 account, they could have almost a million dollars by the time they turn 20!
Can you imagine having over $100,000, let alone $1 million by the time you are legally an adult? Since you worked for your money, you will likely feel like one of the richest and proudest 18-year-olds around. You'd have a massive head start to do more things that interest you.
A child can contribute tax-free money into a Roth IRA if they earn under the standard deduction. Then, the Roth IRA money can compound tax-free. If the child wants to withdraw money from their Roth IRA, they can also withdraw the money tax-free as well! What a no-brainer.
Roth IRA Introduction
The Roth IRA was introduced as part of the Taxpayer Relief Act of 1997. It is named for Senator William Roth. A Roth IRA is a retirement savings vehicle where you contribute after-tax dollars. The investments made in a Roth IRA then get to compound tax-free.
You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA.
If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties.
You may be able to avoid penalties (but not taxes) in the following situations:
- Use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
- Use the withdrawal to pay for qualified education expenses.
- You use the withdrawal for qualified expenses related to a birth or adoption.
- You become disabled or pass away.
- Use the withdrawal to pay for unreimbursed medical expenses or health insurance if you're unemployed.
- The distribution is made in substantially equal periodic payments.
Regret Not Contributing To A Roth IRA
One of my regrets was not contributing to a Roth IRA when I was a senior in college (1998/1999) and my first year of work (1999/2000). After 2000, I was no longer able to contribute to a Roth IRA due to surpassing the income limit rules.
The Roth IRA was still new back in 1998 and I was 100% focused on getting a job my senior year in college. Once I got a job, I set up my 401(k) contribution and focused 100% on not getting fired!
The last thing on my mind was opening up a Roth IRA to contribute $2,000 for retirement. I only had a $40,000 base salary in NYC. At the same time, I didn't think $2,000 would make much of a difference.
This is where financial education and parental guidance comes in. If I was forced to learn about the Roth IRA and the power of compounding, I would have contributed. But again, everyone was still learning about the new program at the time as well.
Now that I think of it, my father did tell me about contributing to a traditional IRA while I was making $4/hour working at McDonald's in 1994. However, I wanted to spend the little money I had on taking my girlfriend out to the movies.
Why You Should Open Up A Roth IRA For Your Kids
Opening up a custodial Roth IRA for your kid is a no-brainer for the following reasons:
- Get them in the habit of saving and investing early on
- Build their work ethic since earned income is required
- Teach them about investing
- Teach them about taxes
- Build their retirement nest egg
- More flexible withdrawal of funds
- Contributing with low or no-tax income
- Save on income taxes for your small business
To repeat, the money contributed to a Roth IRA can be withdrawn at any time and used for anything. Therefore, you can easily see a situation down the road where your kid might want to buy his first car or take an international trip with college friends. A Roth IRA can help pay for these expenses.
Given compound interest is one of the most powerful forces in finance, the younger you open up a Roth IRA, the better. Assuming a 6% investment return and monthly compounding, if you contributed just $6,000 in a Roth IRA, in 60 years the account would grow to about $200,000.
Perhaps most importantly, think about all the miserable people working at jobs they hate. Part of the reason why they can't leave or retire early is because they likely only started investing in their 20s. By contributing to a Roth IRA during childhood, a person could literally have a 20-year investing head start!
A Roth IRA increases a person's chance of experiencing freedom sooner. And freedom is priceless.
Rules For Opening Up A Roth IRA For Your Kids
To open up a Roth IRA for your kids and have the money count, you must follow these conditions.
1) No age minimum limit to open a Roth IRA.
There are no age restrictions for opening up a Roth IRA. Kids of any age can contribute to a Roth IRA, as long as they have earned income. That's right, even babies can have a Roth IRA if they have earned income.
2) Child must have earned income.
Earned income is defined by the IRS as taxable income and wages — money earned from a W-2 job, or from self-employment gigs like babysitting or dog walking. A baby can earn income by being in a photoshoot.
The best way is for your child to earn income from a source other than yourself. Paying your kid to mow the lawn with after-tax money you earned from a job isn't optimal. It's not optimal because you most likely are in a much higher tax rate. You're simply making an after-tax investment like you normally would.
For example, I did a summer job landscaping with my kids. Although the job would cost $5,000 to hire professionals, my kids didn't earn $5,000. Instead, they earned some popsicles, which can't be deposited in a Roth IRA.
3) A parent or adult needs to set up a custodial Roth IRA.
Your toddler or pre-adult child (under 18) cannot open up their own Roth IRA. The adult can open one up with a major brokerage house like Fidelity, Charles Schwab, and TD Ameritrade. Opening up a custodial Roth IRA should take less than 20 minutes.
4) Know the Roth IRA contribution limits.
The Roth IRA contribution limit is $6,500 a year in 2023, or the total of earned income for the year, whichever is less. For example, if a child earns $3,000 babysitting, he or she can contribute up to $3,000 to a Roth IRA. If a child earns $10,000 in a calendar year, he can contribute a maximum of $6,500 to a Roth IRA.
Below is the historical Roth IRA contribution limits chart. The contribution limit generally goes up by $500 – $1,000 every 3 – 5 years. The Roth IRA contribution limit in 2024 rises to $7,000 for those 49 and below. Take full advantage!
Income Sources For Your Kid's Roth IRA
It's best for your kid's earned income to come from a source other than you. Otherwise, you're basically recirculating your family's wealth.
You can pay your kid money for doing work with after-tax dollars once you've fully funded all your tax-advantageous retirement vehicles. However, this money isn't eligible for a Roth IRA contribution if he or she isn't actually don't work for your business.
A lot of parents have wondered whether paying their kids money to do household chores counts as a deduction and eligible for a Roth IRA. Sadly, the answer is no. Doing household chores is simply part of “parental training.”
Your child has to be doing actual work for your business. The child needs to be treated as any other employee or freelancer. The child also needs to also be earning a “reasonable wage.” You cannot pay them $1,000/hour to wash the dishes.
Here are are appropriate income sources for Roth IRA contributions:
- After-tax income from a person outside your family, e.g. your neighbor pays your kid to mow his lawn.
- A job at a company, e.g. your kid works a minimum wage job bagging groceries.
- Your small business, e.g. your kid makes money mixing batter for your cupcake business.
The key is to earn as much outside EARNED income as possible at the lowest tax rate possible. Given kids are mostly focused on school up until they are 18, it's hard for most kids to work too much and make too much money. That is, unless they focus on making money online. Then, the sky's the limit.
Thanks to the standard deduction of $13,850 for singles in 2023 ($27,700 for married couples), your kid can make up to $13,850 a year without having to pay any federal income taxes. Other taxes will depend by state.
Therefore, if your child can earn the maximum Roth IRA contribution of $6,500, all of it will go in as tax-free income. Those investments will then compound tax-free. Depending on the situation, all the earnings can be withdrawn penalty and tax-free.
It is also likely the standard deduction will always be higher than the maximum Roth IRA contribution limit. Therefore, there's a great chance your child could contribute up to 18 years of maximum tax-free Roth IRA contributions before working full-time. Limits may change every year, so always check.
Roth IRA Compound Growth Calculations
To help get you even more excited about opening up a Roth IRA for your kids as early as possible, let's do some compound growth calculations.
Roth IRA Compound Growth Example #1
Let's say you open up a Roth IRA when your baby is born and contribute $6,000 every year for 18 years. Your baby is a model and does other jobs over the next 18 years. By the time your kid turns 18, he or she will have $200,702, assuming a 6.2% compound annual return!
Think about how set your kid would be at 18 with over $200,000. He'll be well past the five-year limit by then. Therefore, he can use the Roth IRA however he pleases. Hopefully, you will be able to teach him restraint and let his Roth IRA money compound for decades longer.
Roth IRA Compound Growth Example #2
Let's say you open up a Roth IRA for your daughter at age 5. Age 5 is about the time when kids can regularly follow instructions and do tasks. You have an online business that requires some photoshoots, video recordings, audio recordings, and editing. You pay your child only $10,000 a year versus $100,000 if you had to hire an adult. What a bargain!
If you contribute $6,000 out of the $10,000 a year for 13 years to a Roth IRA, your daughter would have $129,300 by the time she is 18. Not only that, you can invest the other $4,000 in a taxable custodial investing account that will likely grow as well.
Perhaps even better than having $129,300+ in a Roth IRA, your daughter will have developed an amazing foray of internet skills. She could work for your business as a full-time employee, take over your business, start her own business, or work for another similar business. She'd be so far ahead of the curve compared to kids who just learn and not do.
Meanwhile, your business gets to reduce its taxable income by $10,000. If the business's marginal federal income tax rate is 32%, your business has saved $3,200 in taxes. The higher your business's marginal federal income tax, the more incentive you have to pay your child.
In a real way, paying your child from your private business is fantastic estate planning. Further, paying your child for work is much better than just gifting your child the annual gift tax exclusion amount.
Roth IRA Compound Growth Example #3
Most parents won't have their own businesses or kids who start working so early. Therefore, let's assume your kid starts earning income at age 14 at a traditional minimum wage service job, e.g. waiter. He ends up making $8,000 every summer and winter break.
You open up a custodial Roth IRA and he invests $6,000 a year in a hot tech company. With only $6,000 a year, you guys agree to invest more aggressively. The tech company stock appreciates by 100% a year for four years. By the time your kid is 18, he will have $180,000 in his Roth IRA.
100% a year for four years sounds unlikely. However, such growth rates are everywhere if you look hard enough. By the time your kid is in college, he will most likely be infatuated with investing or technology. His infatuation may encourage him to study finance or engineering. As a result, he may land a role at a lucrative finance or technology firm.
Starting a minimum wage service job at 14 will likely instill in your son a greater appreciation for money and future job opportunities. By working at McDonald's and stuffing envelopes as a kid, at the very least, I knew what I didn't want to do for the rest of my life.
Graphic Of How A Roth IRA Can Grow Over Time
Here's a graphical image from Fidelity on of how much a Roth IRA account can grow depending on age, contribution amount, and returns. If you start contributing to a Roth IRA by age 15, there's a decent chance you'll become a Roth IRA millionaire by 65.
Now, of course, there are no guarantees to investing. It is possible to invest and then experience a multi-year bear market. However, over the long run, stocks and bonds tend to appreciate.
The average return for the S&P 500 since 1926 is roughly 10%. The average return for the less volatile aggregate bond market is roughly 5%.
Opening A Roth IRA For Your Kid Is A Must
Hopefully, you now agree that opening a Roth IRA for your kid is a good idea. The earlier the better.
Even if your kid does not earn enough income to contribute the maximum amount to a Roth IRA, still open one. Knowing the contribution rules and everything else may encourage him or her to work harder and make even more money.
You can open a custodial Roth IRA at any big brokerage firm like Fidelity, Charles Schwab, TD Ameritrade, and so forth. It took me less than five minutes to open one for each child.
You just need to input their name, date of birth, Social Security number, address of residence, and mailing address. Then, for funding, you can either link an account online or mail in a check with your child's Roth IRA account number.
Instill In Your Kids A Strong Work Ethic Too
If you plan to pay your kid for doing business work, make sure your retirement savings are squared away first. After all, you are in a higher tax bracket. Max out your solo 401k, SEP IRA, or Roth IRA first. You don't want to risk your family's financial security before your child has the ability to earn an independent living.
Although I never had the privilege of contributing to a Roth IRA, I will make sure my children do. I'm excited to put my kids to work and teach them everything about online media and investing. My kids can hopefully learn how to become great investors as well with more practice.
There is a risk that our kids could end up blowing all their Roth IRA money on useless things once they become adults. However, when you spend years working hard for your money, wasting money is harder to do. The more likely scenario is that our kids will want to figure out ways to make even more money.
The key is to start educating our children young so that saving and investing becomes a natural way of life.
Roth IRA Tracking Recommendation
Track your child's Roth IRA and your investments using Empower's free financial tools. I've used Empower since 2012 to manage my investment allocations, reduce portfolio fees, and track my net worth. The more you can stay on top of your finances, the better you can optimize.
Invest In Real Estate For You And Your Kids
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are relatively low and stocks are much more volatile.
You are your kids can start investing in private real estate with Fundrise with just $10. Fundrise has been around since 2012 and manages over $3.3 billion for 400,000+ investors.
Fundrise predominantly invests in residential and industrial properties in the Sunbelt region, where valuations are lower and yields are higher. The spreading out of America is a long-term demographic trend. For most people, investing in a diversified fund is the way to go.
I've personally invested $954,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$380,000.
Invest In Private Growth Companies
Finally, invest in private growth companies for the future. Artificial intelligence is clearly going to be a leading technology of change over the next 10-20 years. As a result, I think it's a good idea to gain exposure to funds that invest in AI companies.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. You can see what the Innovation Fund is holding before deciding to invest and how much.
Related posts on Roth IRA:
Disadvantages Of A Roth IRA: Not All Is What It Seems (geared towards higher-income earners)
The Only Reasons To Ever Contribute To A Roth IRA (in addition to helping your children build wealth)
The Making Of 529 Plan Child Millionaires (given the cost of education is so brutal)
How to Open Up A Roth IRA For Your Kids is a Financial Samurai original post. Financial Samurai was founded in 2009 and is one of the largest independently-run personal finance sites with over 1 million organic visitors a month.