4 Reasons Why Your Child Should Open a Roth IRA Before April 15th (May 17 for 2020)!
Updated: Apr 20
Putting off immediate gratification for a delayed reward is a great lesson for any child. My now 13 and 16-year-old kids have had savings accounts since they were 3. Going down to the bank to deposit their hard-earned allowances gives them a sense of joy and pride. But if possible, most parents should eventually move from saving to investing. If your child is lucky enough to have earned income, the best account for this is the Roth IRA.
4 reasons your child should have a Roth IRA:
Roth Reason #1
Investing beats saving (over the long term). Compounding is magical with any account type, but when you add in the higher return potential of investing, the magic is even more spellbinding. Roth IRAs have the potential to hold investments; savings accounts do not. If you consider inflation, investing is more advantageous. A child’s long-time horizon is ideal for investing and the tax-free qualified distributions in retirement will add to the their financial security.
How compounding and inflation might look after saving or investing $300 after 50 years:
Roth Reason #2
A higher tax rate in retirement. One of the debates of post-tax Roth accounts vs. pre-tax Traditional accounts is the uncertainty of whether your retirement tax rate will be higher than your current tax rate. It is a factor in deciding whether it is better to take the tax-deduction now or tax-free funds in retirement. Long-time horizons and low current tax rates are perfect for the Roth, and children have both of these.
If in doubt, please see your tax pro to see how earned income might affect your child’s specific tax situation.
Roth Reason #3
It is a multi-purpose account and college financial aid. One of the main reasons the Roth is considered a multi-purpose account is that contributions are available anytime tax and penalty-free. This feature makes it great for a college fund or an emergency fund (just be careful how you invest). Earnings will be taxed as ordinary income and will also have a 10% penalty if withdrawn before age 59.5. Also, the Roth and Traditional IRAs both have a higher-education feature that includes no penalty on earnings. The earnings will be taxed as ordinary income, but still a nice feature.
As though the Roth wasn’t attractive enough, it is also not viewed as available college-funding assets for most college financial aid calculations, except when contributions or earnings are distributed. Most colleges use the Free Application for Federal Student Aid, or FAFSA. Retirement accounts like the Roth are not taken into account in the financial aid calculation. This applies to both the student and parent. Ignored assets or income means more potential financial aid!
Roth Reason #4
Skin in the game and they will thank you. Children will work harder and get more excited if they have skin in the game. If the child knows they are benefiting from the investment, they will try to learn more and see the correlation between sacrifice and risk and reward. Your child will also thank you for your guidance. Kids don’t always have the perspective to think long-term. Giving your child this perspective will benefit them for a lifetime—most younger financially successful 20-somethings credit lessons taught to them by their parents for their success.
What will you need to open a Roth?
There are no age restrictions for Roth IRAs, but your child needs earned income to open any IRA, including a Roth. Earned income is just like it sounds getting paid for working (participating) in a business or trade. The income can’t come from investments, interest, or dividends. A gift is not considered earned income. The earned income from a “normal” employer is the easiest to use. Not only is there little chance the IRS would question the legitimacy of the W-2 income, but the employer would handle the paperwork and the FICA (Social Security and Medicare) tax withholding.
If you, the parents, own your own business, it can be relatively easy to document the duties and the pay. You may also have experience with the 1099 or W-2 paperwork and tax withholding and reporting.
If, however, you don’t have your own business, it can get a little trickier staying on the right side of the IRS. Generally speaking, day-to-day allowance type work does not qualify as earned income. Specific tasks like babysitting and helping with a house remodel would most likely qualify. The child may also be responsible for the self-employment and income tax payments. There are many different rules around when you must file a tax return, but the main one applicable to most self-employed children is that if they had NET earnings greater than or equal to $400 for 2020, they must file (notice the keyword “net”).
The Roth’s contribution limit for 2020 is $6,000, or the total of earned income for the year, whichever is less.
A parent or adult will need to be the custodian for the child’s account; thus, the account is called a custodial Roth IRA. Even with the parent on the account, most firms don’t offer this type of account. A firm that does and does it for free, or close to it, is TD Ameritrade. There are no account minimums, and buying individual stocks, ETFs, and most mutual funds is very cheap. You don’t want fees to eat up your child’s hard-earned investment.
If there are too many fees, especially with smaller-balanced accounts, the account can’t grow. Ideally, the only two fees should be an expense ratio and a one-time trading fee. The expense ratio should be well below 0.75%, and the trading fee should be no more than $25. Given the low cost of brokerage compared to when I started in this industry twenty years ago, there should really be no other fees for the account.
An Investment Approach
(Investment Policy Statement)
When investing for a child long-term, a simple, diversified, low-cost approach is probably best. This usually means using one broad-based passive index, or index-type mutual fund, or ETF. The goal should be to take advantage of long-term U.S. and/or global growth, not to time the market or stock pick. This long-term, diversified approach should be followed for the core of the child’s investments; there is nothing wrong with letting them have some fun.
As many of you know, the most fun is being had on Robinhood. You can even hear my take from a previous blog post: https://mniceinvestor.com/2020/10/04/robbin-retirement-the-good-the-bad-the-ugly-of-the-new-robinhood-trader/
There is nothing wrong with letting the kids get involved in the gamification of stocks; there can actually be benefits. Both of my sons trade on Robinhood in addition to having their “real” investments at TD Ameritrade. They are very engaged in the business of the companies they invest in, even if for a short time. They also learn about the difference between gambling and investing and the spectrum in between.
Because it is fun, they will take the time to learn things like why airline stocks were so far down during COVID and why they might have upside coming out. They learned that some companies might not make it and that there is risk. The whole process teaches them about risk and return. And no simulation can truly teach them about loss. This was especially true with one of my sons. My warnings could not take the place of seeing a stock he invested in go down just as quickly as it went up.
When we talk about financial literacy, teaching and academics can only take kids so far. Real-life budgets, real-life rewards, and real-life losses are the best ways for kids to be prepared for the real world. When done in a controlled, parent-managed environment, there is very little downside.
A Roth can be part of this real-world experience. It can take a little bit of prep work by the parents, but the long-term return on your time investment will be greater than you can imagine
For information on working with Mark: www.SonaWealthAdvisors.com