For any parent, it’s important to provide the best possible start for their children. One way you can do this is by beginning early with financial investments and planning for their future. Having a Roth IRA in place for your child is an excellent way to take give them a head start with their long-term financial future, no matter how much income they make each year, or what type of work they are doing — from babysitting and mowing lawns to starting their own business. With compounding interest, the power of time and proper budgeting, these investments can become incredibly powerful tools that will result in steady returns during retirement years. Read on to learn more about how setting up a custodial Roth IRA account now can be beneficial to shaping your child’s bright future!
Introduce your child to the power of compounding interest with a custodial Roth IRA
Teaching children about the power of compounding interest can be an important lesson for their future financial success. One way to achieve this is by introducing them to a custodial Roth IRA when they are old enough to understand. This type of account allows parents or guardians to contribute money on behalf of their child and watch it grow tax-free over time. By starting early and consistently contributing, the child can potentially have a significant amount of savings by the time they reach retirement age. Additionally, the custodial aspect of the account allows the child to have control over the funds once they reach the age of majority, giving them an opportunity to learn important financial management skills. Overall, a custodial Roth IRA can be an excellent tool for introducing children to the benefits of saving and investing.
Earned Income Requirement
The big requirement for contributing to a roth IRA, is your child must have earned income. Babysitting and doing yard work are two great options for kids to get started. Babysitting allows them to earn money while providing a valuable service to parents in need of a night out or some extra help. Similarly, doing yard work for neighbors or family members can be a rewarding way to earn some extra cash while getting exercise and fresh air. With some guidance and encouragement, your child can learn the skills needed to excel at these jobs and build a strong work ethic that will serve them well in the future.
Contribution Limits for Each Year
It’s important to understand the contribution limits for this powerful investment tool. The contribution limits vary depending on the year, so be sure to check it out each year. In 2023, the Roth IRA contribution limit is the lesser amount of $6,500 or up to the max amount of earned income for that child for the year. For example, if they made $2,000 babysitting in 2023, they could invest up to a max of $2,000 to their Roth IRA. Having children fork over the money to something they won’t benefit from for a long time might be a hard no for them. The beauty is that as long as they have earned income of at least the amount contributed, it doesn’t matter where the money actually comes from. So if you wanted to invest your own money into their account, you can! One thing to consider is they may have to pay self-employment taxes on their earned income. Be sure to check with a tax professional.
Max Income Limit
While it’s not likely your child will meet the max income limit, it’s important to know that there is one. For dependents, they cannot contribute to a Roth IRA if their modified adjusted gross income (MAGI) is $138,000 or more.
The Power of Compounding Interest
Time is a powerful force that can work either for or against you. When it comes to investing, time can be your greatest ally. For example, if you/they contributed just $1,000 one single time to their Roth IRA. In 55 years, that $1,000 would have grown to over $68,000 (with an average return rate of 8%). If they started later and contributed the same $1,000 one single time, but only had 40 years for the money to grow, it would only be worth approximately $21,000 (at the same 8% average return rate).
Another example: If you/they contributed just $1,000/year for only ten years starting at age 10 (so ages 10-20) and they never contributed anything else, 55 years later (at age 65), they would have over $848,000 saved. You/they only invested $10,000, the rest was interest earned. If they didn’t start investing until they were 25, and invested $1,000/year for 40 years (30 extra years for a total of $40,000 invested), they would only have approximately $259,000. That’s $589,000 less even though they contributed $30,000 more total over the years. Time is the most powerful thing!
If you’d like to play with a compounding interest calculator, my favorite is Bankrate’s.
Additional Benefits of Roth IRA
A huge benefit to a Roth IRA is that it’s funded by post-tax contributions instead of pre-tax contributions. This means that as long as you take qualified distributions, you won’t have to pay taxes on the contribution amount or the earned interest when you withdraw the money during retirement. A pre-tax funded investment vehicle (such as a 401k or standard Roth IRA) saves you on taxes in the years that it’s initially funded but will be fully taxed when you retire and begin taking qualified distributions. As an adult with higher incomes, it would be best to consult a financial advisor to see which investment vehicle might be right for you. For children with little income, a roth IRA is usually a clear win because since they don’t usually make a substantial income, they typically owe little to no taxes. They will also have a significant amount of earned interest at retirement age that will be tax free.
Another benefit to a Roth IRA, is that after having the account open for five years, regardless of your age, you can take withdrawals penalty-free and tax-free on your CONTRIBUTIONS (the amount you actually invested). If you withdraw more than you contributed (your earnings), penalties and taxes will likely apply unless you meet certain strict requirements. This can be beneficial for young adults who want to buy their first house or need to pay for college tuition. If they just withdraw their contribution amount, they will still have the interest that they have earned that will continue to grow until retirement.
By introducing your child to the concept of compounding interest, they can understand how investment principles work and have a solid foundation for achieving financial success in their future. They will also be well on their way to saving for retirement with a lot less money required when they start earlier. Finally, emphasizing how compounding interest is invaluable and how early saving can play into greater returns later on will give your child a better appreciation for the sheer power of time and its positive importance in their life. Encourage your children to take advantage of this knowledge and put it into action. With proper guidance and growth mindset, young people everywhere can build wealth for their futures!