Once your child starts working, help him/her develop good savings habits by encouraging him/her to fund an individual retirement account (IRA). Even if your child only contributes for a few years, an IRA can provide significant funds for retirement.
Your child must have earned income to contribute to an IRA and may only contribute the lesser of earned income or the maximum IRA contribution. The maximum limit is $5,500 in 2014.
Assume your 16-year-old daughter starts working part-time. If she contributes $2,000 to an IRA from the age of 16 to 22, she will contribute $14,000 over seven years. With no further contributions, the IRA could potentially grow to $527,437 on a tax-deferred or tax-free basis by age 65. That assumes earnings of 8% compounded annually, but does not include any income taxes that might be due.
If your child continues $2,000 IRA contributions until age 65, she would make total contributions of $98,000 and could accumulate investments of $1,145,540. (These examples are provided for illustrative purposes only and are not intended to project the performance of a specific investment vehicle.)
Although most children will be eligible to contribute to both a traditional deductible IRA and Roth IRA, you should probably encourage your child to fund a Roth IRA, which has several advantages:
- Roth IRAs are more flexible. Your child can withdraw all or part of his/her contributions at any time, without paying federal income taxes or penalties. Thus, if your child later decides to use contributions for college, a car, a down payment on a home, or for some other purpose, contributions can be withdrawn with no tax consequences.
- Earnings accumulate tax free, plus qualified distributions can be withdrawn tax free. A qualified distribution is one made at least five years after the first contribution and after age 59½. There are also certain circumstances where earnings can be withdrawn without paying income taxes and/or the 10% federal income-tax penalty. If your child allows the funds to grow until at least age 59½, all contributions and earnings can be withdrawn without paying any federal income taxes.
- A traditional deductible IRA offers little tax benefit to a child. When your child first starts working, he/she will typically pay a low marginal tax rate on his/her income. So even though the Roth IRA contribution is not tax deductible, your child typically receives little or no tax benefit from deducting the traditional IRA contribution anyway.
If you can’t convince your child to use his/her own money to fund the IRA, consider reimbursing him/her, as part of your annual gift-tax exclusion, for any IRA contributions. Hopefully, you will also teach your child some important lessons about saving at an early age. Please call if you’d like to discuss how to implement this strategy for your child or grandchild.
Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.