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Here’s a very good idea to consider – if you have a teenager who has a part-time job, rather than putting those earnings solely into a savings account (or worse, a car), open a Roth IRA. The money contributed to this account will mostly be tax free, since the first $12,400 (2020 figures) of earned income is not taxed for a single filer that is a dependent of another.
Since contributions to the Roth IRA are “after tax”, the first $6,000 earned (for 2020) and the future earnings on that income will never be taxed if contributed to a Roth IRA. And since as a parent you’re paying for most everything else that the child needs anyhow, why not encourage him to make a contribution of his first $6,000 of income into a Roth IRA?
One downside (or maybe it’s an upside?) to this strategy is that the contributions will be available (without tax or penalty) for college expenses, down payment on a home, or whatever. However, if the money is left in the account it can provide a tax-free source of income for retirement in the future. This can be a good time to introduce the concept of long-term savings to your child.
An added benefit of putting the money into a Roth IRA account is that money in retirement accounts (such as a Roth IRA) is not included in the FAFSA calculations for student financial aid. If this money was put into a standard passbook savings account, the savings account would be counted as a source of funds to pay for college expenses (on the FAFSA).
Two key factors to remember are:
- The child must have earned the income. This means that the income was reported to them on a W2 or 1099, or possibly the child was self-employed. The income must be reported on an income tax return in order to account for the income, even if no tax was owed on the earnings. (Note: don’t get carried away with this idea and “invent” income for your child. Allowance for mowing the yard or cleaning her room does not generally count as income.)
- The Roth IRA contribution must be made before the tax return is filed for the year in question. For the 2020 tax year, for example, the contribution to the Roth account must generally be made by April 15, 2021.
Sterling Raskie, MSFS, CFP®, ChFC®
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I would suggest a variation of this to encourage good habits –
Talk to your child about Roth/retirement accounts. Then offer to help the child open an account and reimburse for all contributions up to their earnings or a specified amount agreed in advance. BUT you will not reimburse them until later on (like 2-4 times a year and make sure they realize that). You want to enforce not only saving/investing but also delayed gratification (as in getting reimbursed).
Have your child pick the investments, with your guidance, so they will get interested in the account and it’s growth. And if they pick poorly, let them learn now while the balance is low. This may result in them working harder to get a higher income as they get older and learning to make good investments.
Some really great ideas to involve and teach a child about saving and investing – thank you!
Great article Jim! For those parents with the financial wherewithal to do so, I recommend they incentivize their children’s ROTH IRA contributions. Parents should consider creating a family matching program. I gave my child 25 cents for every dollar he put into his ROTH IRA. My program ended once he completed his undergraduate degree. This approach makes it more appealing to save for a retirement 40-50 years down the road, a financial concern most teenagers would perceive as too remote to address. It also teaches them the significance of matching contributions, so they are prepped to see the imperative of contributing to an employer’s retirement plan, at least to the extent that the employer matches their contribution. Parents should also encourage their children to leave their ROTH funds untouched, hopefully being the last money they ever access. Taking this approach increases the odds that your children internalize the importance of financial planning, both in general and specifically for retirement.
Thanks, Scott. This is one of my favorite topics to talk to parents about. And your matching program is a great idea, thanks for sharing!