Encouraging Children or Grandchildren to Make Roth IRA Contributions

Federal employees and retirees who have teenage or college-age children who are working this summer are advised to encourage their children or grandchildren to contribute at least a portion of their earnings to a Roth IRA.

This column discusses the benefits of a child regularly contributing to Roth IRA starting when they are in high school or college.

It makes no difference what particular job a teenager or college-age student is performing this summer and being paid for his or her services. The teenager or college-age student could be working as a camp counselor at a summer camp or as a lifeguard at a pool, doing a summer internship, or working at a fast-food restaurant.

For many of these children, a summer job can teach valuable life skills and give them the first opportunity to manage their finances. And an important part of managing their finances is saving for the future including saving for their retirement. In so doing, they will get a head start on saving for their retirement years while getting the experience and learning the importance of saving on a regular basis.

What is perhaps the best and most efficient way for a young person to save for his or her future retirement? A young person with some earned income is advised to contribute to an individual retirement arrangement (IRA).

There are two reasons why contributing to an IRA is the best and most efficient way for a young person to save for their future retirement. They are:

(1) The tax savings; and

(2) Compound investment tax-free or tax-deferred growth in their savings compounded annually over a 40-to-50-year or more period of time.

A young person with earned income is eligible to contribute to two types of IRAs, a traditional IRA or a Roth IRA. Which type of IRA would be a better choice for a young person who is beginning to save for retirement? Most tax professionals would say that a Roth IRA is a better choice.

While contributions to a traditional IRA would be tax deductible resulting in current year tax savings (the year in which a contribution is made), few young people will earn enough of a salary to benefit in tax savings currently by contributing to a traditional IRA. On the other hand, while Roth IRA contributions are not tax deductible, Roth IRAs offer potentially tax-free compounded earnings growth over time.

By starting to contribute to a Roth IRA a teenager will have the important advantage of time in the sense of tax-free investment growth over hopefully a lengthy period of time.

Consider the following example:

Jesse, age 18, earned $1,000 during July and August 2023 working as a lifeguard. Jesse wants to take his $1,000 earnings and make his first Roth IRA contribution. With the help of his parent’s financial advisor, Jesse invests in an open-ended stock fund having an historical average investment return of 7 percent. Jesse intends to continue contributing $1,000 to his Roth IRA for the next 47 years until he is age 65. Although past investment performance is no guarantee of future performance and assuming a 7 percent average investment return over the next 47 years, by the time Jesse is 65 years old his Roth IRA account will be worth $353,270 which Jesse will be able to withdraw at that time income tax-free.

Jesse when he is age 65 and retires and no longer contributes to his Roth IRA and does not withdraw from it. Assuming the same 7 percent average investment return (once again, past investment performance is no guarantee of future investment performance), using the investment “rule of 72’s”, by the time Jesse is age 75, his Roth IRA will double in value and be worth approximately $706,540. Wait another 10 years and by the time Jesse is age 85, his Roth IRA will according to the “rule of 72’s” double in value to approximately $1,413,080.

Rules for Making Roth IRA Contributions

In order to make a Roth IRA contribution, an individual must have taxable earned income. Wages/salary from a summer job or an after- school job during the school year qualify as taxable earned income. For 2023, the Roth IRA contribution is limited to the lesser of $6,500 or the total of earned income during 2023. In the example above with Jesse, he earned $1,000 as a lifeguard with no other earned income during 2023. Therefore, Jesse’s Roth IRA contribution is limited to $1,000 for the year 2023. There is no requirement that Jesse contribute the maximum amount to his Roth IRA that he is eligible to contribute to. If Jesse decides he wants to contribute only $500 to his Roth IRA for the year 2023, then he could make that amount of a contribution. Any amount that Jesse decides to contribute to a Roth IRA is a good start.

Another consideration for a child or grandchild to make a Roth IRA contribution is that a parent and/or a grandparent can contribute to the Roth IRA on behalf of the child/grandchild. There is no requirement that the contribution had to come from the earned income of the child/grandchild. In Jesse’s example, if Jesse contributes $500 to his Roth IRA for 2023, then it is possible that Jesse’s parents could contribute $250, and Jesse’s grandparents could contribute another $250 to Jesse’s Roth IRA on his behalf for the year 2023.

While there is no minimum age for establishing an IRA under the law, some IRA custodians may have policies restricting IRAs for minors. However, there are other IRA custodians who will allow minor children to establish IRA accounts.

There is no doubt that a summer job provides many benefits to a young person. Establishing and contributing to a Roth IRA is obviously one of the more important benefits. Contributing all or a portion of the young person’s earned income to a Roth IRA will enable the young person to ideally get in the habit of regularly saving and learn valuable lessons about preparing for their future retirement.