Imagine your teen has just landed their first summer job at a local cafe. It’s an exciting time, and while they might be dreaming of spending their hard-earned cash on the latest fashion or video games, you see a valuable teaching moment. Why not introduce them to the concept of investing? A Roth IRA could be an excellent start for them to begin building a nest egg early, reaping significant tax advantages along the way. 

Whether your child’s still in diapers or gearing up for college entrance exams, setting them on the path to financial independence is more manageable than it might seem. Let’s take a look at how you can open a Roth IRA for your child and the benefits of doing so.

What Are the Roth IRA Contribution Rules for Children and Teens?

Contributing to a Roth IRA doesn’t have an age requirement. Whether your child is a toddler or teenager, they’re eligible to contribute to a Roth account as long as they have earned income within the year.

The amount they can contribute is directly tied to their earnings—meaning their annual contribution can’t exceed their earned income. If your child earned $3,000 babysitting and mowing lawns this summer, that’s the maximum they (or you) can invest in their Roth IRA for the year. However, you and your child are bound by the standard annual Roth IRA contribution limits, which for 2024, stands at $7,000.

What Is Considered “Earned Income”?

As we mentioned earlier, there is no age limit on opening a Roth IRA; the key requirement is that they must have earned income. But what counts as earned income for a child in the eyes of the IRS?

Earned income includes wages from formal employment, such as working part-time at a local grocery store or a pizza shop. Even young children involved in activities like modeling can earn a paycheck. Qualifying income can also come from “net earnings from self-employment,” which may not yield them a tax form like a W-2 or 1099. This might include babysitting, dog walking, or other odd jobs. For these types of earnings, it’s crucial to keep detailed records and receipts of the work performed and income received to ensure compliance with IRS requirements.

Just as important, the type of income that doesn’t qualify includes:

• Investment income
• Gifts from family or friends
• Allowances

Should You Hire Your Child in the Family Business?

If you’re self-employed or own a business, consider the dual benefits of hiring your child. This can be an effective way to help them earn an income while also reducing your personal and business tax liability.

First, your child’s wages are a business expense, reducing your taxable profit. Additionally, under certain business structures, their earnings might be exempt from payroll taxes such as Social Security, FUTA, or Medicare, depending on their age and other IRS rules.

Their earnings may also be exempt from income tax or, at least, taxed at a lower rate than what you and your spouse may be subject to. And because they are earning income, they become eligible to contribute to a Roth IRA—or you may contribute on their behalf (just remember, you can’t contribute more than what they earn).

The Long-Term Benefits of Starting a Roth IRA Early

One reason some people shy away from Roth IRAs is that they don’t reduce your taxable income for the years contributions are made since the account is funded with after-tax dollars. This is the trade-off for enjoying tax-free income in retirement.

But, for young earners like children or teens with part-time jobs, their overall taxable income is usually minimal—possibly even zero. If your child is a minor claimed as a dependent on your tax return, they will typically only owe taxes if the income exceeds the standard deduction ($14,600 for 2024).  

Anything earned below the standard deduction can be enjoyed tax-free—meaning those Roth IRA contributions enjoy even greater tax benefits:

• Tax-free contributions
• Tax-deferred growth
• Tax-free qualified withdrawals 

Even if your child has aged out of dependent status yet continues with part-time work, they can still capitalize on their lower tax bracket. In 2024, if your young adult child’s adjusted gross income (AGI) remains below $11,600, they’ll be in the lowest tax bracket—10%. This rate is considerably lower than what they may face in their peak earning years and subsequent retirement. Though they’ll still have some tax liability, it may be significantly less than what they can expect to pay later on in life.

The Power of Compounding Interest

Starting a Roth IRA for your child sets a foundation for their financial future by maximizing the potential growth period before retirement. Time, above all else, is the most effective tool for investment growth, thanks to the power of compounding interest, ie, the interest earned on both the money contributed to an account and the interest it’s already earned. 

Say you help your child open a Roth IRA with an initial investment of $500, which earns 5% in interest annually. For every month afterward, your child contributes another $100. This goes on for five years, and the interest compounds annually.

After five years, your child will have contributed a total of $6,500 to the account, yet the account will be worth $7,269. And, if they continue that habit of investing $100 a month until they turn 65, assuming an 8% average return, they’d end up with about $700,000. Multiplied over decades, compounding interest enables your child’s account to grow significantly. To put this into perspective, starting at age 14 means your child could have close to $1 million by the time they turn 65, all from the habit of investing just $100 a month.  

Help Your Child Start Their Wealth-Building Journey Now

Helping your child contribute to a Roth IRA is not only a wise financial decision but also a powerful educational tool. By involving them in the process, you’re helping your child understand the value of hard work and the importance of saving over spending. These lessons in financial responsibility and independence are invaluable, equipping your child with the skills to make informed financial decisions and become financially savvy adults in the future.

If you’d like to explore more strategies like this or need help with financial planning for your family, reach out to us at Lake Road Advisors. We’re here to help you make smart money moves that benefit your whole family.

Sources:

1. https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000
2. https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/earned-income-and-earned-income-tax-credit-eitc-tables
3. https://www.kitces.com/blog/tax-rules-hiring-children-family-business-flsa-tax-savings-standard-deduction-roth-contribution/
4. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024
5. https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator

Lake Road Advisors, a Fee-Only, independent financial planning firm with offices in Corning, NY, Ithaca, NY and Portland, OR works with clients virtually all across the country. Paul Sydlansky, the founder of Lake Road Advisors LLC, has worked in the financial services industry for 20+ years. Prior to founding Lake Road Advisors, Paul worked at Morgan Stanley in Manhattan for 13 years. While at Morgan Stanley, Paul was a senior-level manager within the Institutional Equities Department. In 2018 he was named to Investopedia’s Top 100 Financial Advisors list. Paul received a Bachelor’s degree in Economics from Marist College and holds an MBA from New York University Leonard N. Stern School of Business. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network. They can be reached by phone at the Corning, NY office at (607) 438-2914, Ithaca, NY office at (607) 463-8400, or Portland, OR office at (607) 292-2172 or at the firm’s website at https://lakeroadadvisors.com/

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.