Why We Opened Roth IRAs for Our 17 Year Old Sons
Roth IRAs are the supreme retirement saving vehicle at certain income levels. In the late 90’s, the Roth IRA was established after the passing of the Taxpayer Relief Act of 1997. At the time, we were the ripe old age of 25 and expecting our first son. Cool – our oldest son is about the same age as the Roth IRA!
About 20 years later – our family is using the Roth IRA as a powerful tax-efficient tool to start retirement savings for the next generation.
First, a quick summary of the pros and cons of the Roth IRA:
When to Consider Using the Roth IRA
The key advantage to contributing to both a Roth IRA and pre-tax options is that you have more flexibility in retirement to draw from pre and post-tax income streams. This gives you control over how much taxable income you have later and hopefully allows you to reduce your tax bill considerably in your draw-down phase. The Roth IRA is superior to a taxable investment account because the earnings are not subject to income taxes either now or later if you follow all the rules. Wait, I thought Roth IRA money goes in after-tax? That’s right, but when your earnings are really low, you may not owe Federal or State Income taxes, read on. Further, because current rules allow you to pull out your contributions for any reason if you need to – many people view their Roth IRA as an option to park emergency reserves.
Unfortunately, we make too much money now to contribute to a Roth IRA for our own retirement savings (however, when we stop working we plan to convert some of our traditional IRA funds to Roth IRAs in small increments to reduce taxes on future withdrawals).
Thankfully, once your Roth IRA is established, your funds are protected from future taxation even if your earnings rise above the income limits. If you expect to earn more over your working years (who doesn’t?) than you may want to consider contributing to a Roth IRA early in your working career to lock-in those tax-free savings!
Who Would Get the Greatest Bang out of Roth Contributions?
The short answer is individuals with tax-free earnings! Second, would be those in the lowest tax brackets now who expect to earn more later and thus be subject to higher taxes.
Are there any Age Minimums?
No, but you must have earned income.
Enter The Custodial IRA
A parent can open a Custodial IRA for any minor child who has earned income. A custodial account is managed by the parent, but the account belongs to the child and must be transitioned to the child at age of majority.
We wanted to take advantage of the opportunity to start their retirement savings right away. In 2015 and 2016, the standard deduction was $6,300 (it’s $6,350 in 2017). They each could have earned up to $6,300 and not owe any federal or state income taxes. Both years, the Roth IRA contribution limit was $5,500 (same for 2017). In theory, they could both contribute up to $5,500 of their earnings to a Roth IRA to lock-in those tax-free savings for their future selves.
I know not many 17 year olds are thinking about retirement. As a parent, you could consider funding a Roth IRA for your child if they have qualified earnings. This is what we decided to do. Of course, this only makes sense if your own retirement savings is on track. You shouldn’t sacrifice your own retirement savings in favor of starting your child’s retirement fund, especially if it means giving up employer match. However, if you are like us and already maxing out your own savings, you have sufficient savings to cover college costs and you are interested in eventually gifting or leaving a small inheritance for your children anyway – why not do so now and let the power of time make your gift more valuable?
You can only contribute up to their qualified earnings. If they only earned $2,300 – that’s the maximum you could consider for that year. Perhaps you are willing to match 50/50 for what he/she wants to contribute?
The Future Value of a Roth IRA Gift
For illustrative purposes, let’s look at a simple investment projection for a $3,000 contribution at age 18 (the lowest age this calculator would allow us to put in) vs. the same $3,000 contribution at age 25 (7 years later).
You can run your own projections on a number of sites, but if you want to use the same one we used below, here is a link to Scottrade’s:
The assumptions used in these calculations include Moderate Growth with 27% Large Cap US, 12% Mid Cap US, 7% Small Cap, 24% International, 26% Bonds, and 4% Cash.
A simple, one-time contribution of $3,000 at age 18 would have $18,251 more in value after 40 years! The initial deposit of $3,000 could grow to over $40,000 in 40 years.
If your child contributed an additional $1,000 a year, the projected value of the account would be over $254,000 after 40 years and could have $101,000 in higher value than if started at age 25. Those extra 7 years really make a difference!
Who knows what a quarter of a million dollars will be worth in 2057, but it’s likely that your child will be able to contribute more than $1,000 a year when they start working full-time, right?
Plus, once your child is over age 19 and no longer your dependent for tax purposes (after they finish school) they may be able to take advantage of The Saver’s Credit when they contribute to an IRA. Read more about The Saver’s Credit here.
On top of the future growth potential, the other reason we feel this a great idea for parents to consider is that it opens up dialogue with your child about saving habits, income taxes and the magic of compounding when you save at an early age. Instead of talking about abstracts, you have a real-world example in their own retirement fund!
It could also lead to conversations about your own retirement plans vs. your expectation of them for self-reliance once they have left the nest. Our sons, for example, know that we are making these small gifts now to get them a head-start but we expect them to take full control of their retirement saving and planning once they get their careers started. We are happy to offer some guidance if they have any questions.
Why Not Go With a Traditional IRA?
A Traditional IRA would be a wasted opportunity when there are no income taxes due on current earnings. With income below the standard deduction limits, no Federal or State Income tax will be due (Medicare and Social Security Taxes will). If they instead contributed to a Traditional IRA, future withdrawals will be taxable at any age. Now is a perfect time to build a Roth account, which they will be able to withdraw tax-free later in retirement. As earnings increase over time, pre-tax options become more attractive and valuable. Contributing to both is also an excellent strategy depending on overall income level (just not during super low earning years).
Early Results for Son #1
So we opened a Roth IRA in 2015 for Son #1 at age 17 and contributed a ‘starter’ contribution of only $1,500. We agreed to contribute a very modest $50 a month if he remained employed. We have contributed an additional $650 since then.
Son #1 has been reading more about Roth IRAs and investing in general and he decided to contribute an additional $1,000 of his own earnings towards his 2016 contribution limit and has increased his monthly deposits to add an additional $100 of his own money for 2017. That means for 2017, contributions will total $1,800 but he could contribute more (up to the max of $5,500) if he decides to later. I really wasn’t expecting him to contribute for several years so this was a pleasant surprise for mom!
Looking for a Roth IRA Provider for Minors?
Initially we used T.D. Ameritrade because they have very low minimums to open an account. Charles Schwab also offers Custodial IRAs for minors. Recently for Son #2, we decided to use Vanguard who has a minimum of $3,000. This did require us to provide a larger starter contribution, but we will back off the $50 monthly contributions in the spirit of equity among siblings until they are even in total contributions. In this way, we were able to simply pre-load future contributions for him and he had qualifying earnings well over $3,000 in 2016. We probably would have done $3,000 for Son #1 in retrospect. I like the idea of contributing a small amount monthly to establish good saving habits and it’s sort of like a parental-version of the employer match they may earn in the future. At just $50 a month, this is not effecting our overall family budget or other savings.
Note: Most providers will require that you do paper applications for Custodial Accounts. We had to mail the paperwork in for both T.D. Ameritrade and Vanguard since the account was for a minor.
It feels good to help your children. We probably have made many mistakes as parents over the years, but this is one thing we feel that we did right. We want to shape our children into careful planners and savers and this is a good start. An early jump on their retirement savings will really open up options for them later in life.
Have you opened a Roth IRA for a child? Or will you consider doing so when your children are older?
Did you open a Roth IRA for yourself at an early age? If so, what prompted you to do so?