One of the questions we receive most often is, “How can I help my child (or grandchild) get a great financial start in life?” While there are many strategies to consider, a Roth IRA is often at the top of the list.
Tax-free benefits during retirement. Roth IRAs come with one of the greatest financial advantages of any account: tax-free growth. Money deposited into a Roth IRA has already been taxed. Any future growth in the account is never taxed, as long as the rules are followed.
For example, a hypothetical 19-year-old who contributes $5,000 a year to a Roth IRA, and earns 8% annually for 40 years, would be positioned to have about $1.4 million by age 59. All of the funds would be tax-free when withdrawn after age 59½.
Greater earning potential, thanks to the magic of compound interest. Setting up a Roth IRA for a teenager is a great way to introduce them to basic financial concepts, such as compound interest. Giving your teen a hands-on learning experience may help them understand the value of saving for the future and spark interest in investing and financial independence. You might be helping your child or grandchild to develop lifelong financial habits.
Access to your contributions, tax and penalty-free. Roth IRAs have a very unique characteristic when it comes to the withdrawal of basis. In a Roth IRA, basis is what you have contributed. For example, if you made 3 years of contributions of $5,000/year, your basis is $15,000. Roth IRA rules allow account owners to remove the basis from the account at any time and for any reason, without taxes or penalties. This rule gives Roth IRAs an element of flexibility that is often absent in retirement accounts.
Following the rules is critical. The rules are simple, but important. In order to take advantage of the tax benefits offered by Roth IRAs, withdrawals must be taken after age 59½ and after a five-year holding period. If you do not satisfy these two rules, your earnings may be subject to income taxes and a 10% penalty. There are exceptions to the rules:
If you withdraw earnings before age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties. The taxes are not avoidable, but you may avoid penalties under these conditions:
- You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
- You use the withdrawal to pay for qualified education expenses, for qualified expenses related to a birth or adoption, or to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
- You become disabled or pass away.
- The distribution is made in substantially equal periodic payments.
If you withdraw earnings before age 59 ½, but you satisfy the 5-year rule, your earnings will not be subject to taxes and you will avoid a penalty if the same conditions listed above are met.
Rules for gifting a Roth IRA. Roth IRAs can be set up for minors as custodial accounts, which means that the account is the minor’s property with a custodian (usually the person making the gift) in place to protect the minor’s property until he or she reaches the age of majority.
Contributions can be made to custodial Roth IRAs up to the amount of taxable income that the minor has earned or the annual contribution maximum, whichever is less. For example, if your 15-year-old has earned $5,000 at a summer job, you can gift them up to $5,000 to invest in a Roth IRA, despite the fact that the maximum contribution limit in 2020 is $6,000 for those under age 50.
Helping parents and grandparents guide younger generations of family toward stable financial lives is a passion of ours. We’re aware that every family is different and that solutions work best when they are tailored to specific needs. We would be honored if you allowed us to help you achieve your family’s financial planning goals.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.