Summertime brings a break from school, and for many students that also means working. During the summer months, a student can make some pretty good money – maybe enough to help pay for the next semester of school, or saving up toward a replacement for the old car they’ve had for a while. It should also be part of the plan to save some of the earnings for longer-term concepts – a house in the future, and yes, even retirement. This is where a Roth IRA for a student comes into play, and it can really make a lot of sense when you look at it.
Saving regularly, beginning with the first money a student earns can swiftly become a habit. This habit will serve the student well, long into the future. But there are current benefits to the saving habit as well.
Benefits of a Roth IRA for a student
When a student saves money by contributing to a Roth IRA, an interesting thing occurs: since the majority of the earnings (if not all) are less than the taxable minimum, by putting the money in a Roth IRA, this money will never be taxed. This is to assume that the money is left in the Roth IRA until retirement or some other qualified distribution.
Because the Standard Deduction in 2018 for a dependent of another taxpayer is “the total earned income plus $350, up to $12,000”. So the student could earn up to $12,000 over the course of the year (from a summer job and perhaps part time jobs during the school year, for example) with zero taxes! And from this $12,000, the student could contribute up to $5,500 to a Roth IRA in 2018.
Of course, it may not be reasonable for the student to put aside so much of his or her earnings. After necessary expenses, some gas money, and a bit of “mad” money, maybe there’s only $500 or $1,000 left for savings. Any little bit can be a good start! It might be a good idea to set a specific percentage aside for long-term savings, like 10% of each paycheck, to get in the habit of paying yourself first. This is, as you might recognize, an excellent way to augment saving activities by making it a personal requirement of every dollar earned.
In addition to the “never to be taxed” factor, consider this: by comparison to a standard savings account, a Roth IRA for a student does not need to be considered as a source for FAFSA (financial aid) calculations. This is because the Roth IRA is a retirement account, and as such is not included in FAFSA reporting. For some students, this can make a difference in financial aid.
Being a retirement account, there are legal hindrances to early withdrawal – which might keep the temptation to withdraw at a minimum. This way, the savings habit can continue and returns can compound over a long period of time. That $500 or $1,000 saved this year can grow to an impressive sum over time. If $1,000 is set aside for a 20-year-old today and left alone at a modest average return of 5% per year, after 40 years it can build to more than $7,000. Continued saving will, of course, have a much more dramatic effect: if another $1,000 is set aside every year for those 40 years, it could grow to $137,000!
Sterling Raskie, MSFS, CFP®, ChFC®
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And if you’ve come here to learn about queuing waterfowl, I apologize for the confusion. You may want to discuss your question with Lester, my loyal watchduck and self-proclaimed “advisor’s advisor”.
I’d like to know filing tax return part for the kid’s earning before contributing to Roth (great idea for kids put in Roth).
what is the maximum amount one can earn so he or his parents don’t have to bothering file or pay tax such as FICA, or self-employed tax…etc. either parents tax return or file his own return.
thanks
Linda, if I understand your question correctly, there are two separate issues. The first issue is: does my child need to file a tax return, pay income taxes and/or pay employment taxes if they are working and/or are self-employed. The answer is, it depends and it is somewhat complex. You should search the IRS website for publication 929 to gain an understanding of the tax law on this topic or discuss it with your tax preparer. Unfortunately, it appears this publication has not been updated for the new tax law. I have not seen any info on if/how the new law impacts dependent filing requirements or taxation. One place to assess impact would be at TurboTax’s Taxcaster page, which allows a comparison of 2017 and 2018 tax liability. You could plug in some projected numbers and compare 2017 to 2018 results. TurboTax periodically updates this site, as more info becomes available.
The second issue is should your child have a ROTH IRA. To me that is an independent question, for you and your child to consider. If they have income, they may have to file a tax return and they may owe taxes. If they have income they may also contribute to a ROTH IRA. The two issues are separate. The only way to avoid the tax issue is to limit your child’s income. Having the ROTH IRA requires the existence of income and the contribution is potentially capped by the amount of income. Every person will have a different viewpoint and they have to decide what is right for their family. For my family, I was unfazed that my tax filing workload increased because my child wanted to work hard and earn more. The long-term dividends paid from the learned work ethic, far outweighed any extra effort on my part. Best of luck deciding how to proceed.
One additional suggestion, for parents who have the financial wherewithal and the desire to incentivize saving for the future, is to create a parental matching program. Several years ago, I wanted to encourage my child to regularly save, so I promoted ROTH IRA contributions with a matching percentage, during his high school and college years. A key rule was that the match was to be saved, either in greater ROTH contributions or if this was not possible, into an emergency fund. I feel this process reinforced positive financial behavior that continues to this day. Of course YMMV.
Very good strategy and one that is likely to help get the student in the mode of saving!
Thanks for the suggestion!