Setting up a Roth IRA for your teenage children
Myron Yaster MD
Today’s PAAD has absolutely nothing to do with pediatric anesthesia and is probably of no interest to the 30+% of you who live and work outside of the United States. So, if you live and work outside of the U.S., you can probably stop reading now and we’ll see you tomorrow with our regular PAAD reviews. However, for those of you who do live and work in the U.S., today’s PAAD will be about gifting and creating a Roth IRA for your children. Yes, your children or grandchildren!
Why am I writing about this now? It is graduation season and many of you have teenagers about to start summer jobs, baby sitting, cutting the grass, life guarding, camp councilors…you get the picture, I wanted to take this opportunity to share the benefits of a little known feature of Roth IRAs. First, I am not a financial analyst and the strategy I am about to describe is one that I used with my own kids and I’ve seen the benefits of first hand. Don’t take my word for this. You should absolutely discuss this strategy with your financial planners and accountants before embarking on it. But if you do, you will never regret it. Indeed, it is so powerful, that before I retired, I taught all of my students and colleagues about it as part of my role as a mentor and I thought I would share it with all of you today. I learned about this strategy from my own financial guru, Dr. Ivor Berkowitz when he took me under his wing when I was a young faculty member at Johns Hopkins as well as from a newsletter, the Independent Vanguard Advisor, that he got me hooked on. Indeed, today’s discussion is based entirely on a recent article in the newsletter.
https://mail.google.com/mail/u/0/?tab=rm&ogbl#inbox/FMfcgzQVwngWzwmrcWHttBJCNvgTjtst
How it works
Once someone starts earning income, they are eligible to contribute to a retirement account. Even if that earner is a teenager working part-time or picking up a summer job, they can start building a retirement nest egg. After opening a Roth IRA in your kid’s or grandchild’s name, you and they can invest up to $7,000 after tax dollars a year. (And by the way, it doesn’t have to be a family member. You can do this for any teen you want to help out.) Over time and with the magic of compounding interest, these Roth IRA contributions will grow, depending on how their investments grow, almost exponentially with time.
Obviously, convincing your teenager that they should invest their hard earned money into an account that they will benefit from 40+ years in the future is a hard sell. A simple solution is to simply fund it yourself. However, because I wanted my own kids to put skin in the game I had them invest a small portion of their earnings and matched their contributions 5 or 10:1 (to the maximum $7,000). A key feature of this strategy is you do have to report the income to the IRS and you will have to pay taxes on this income even if your neighbor is paying your teenager cash for their services. Remember the trick is that you have to declare this income and pay taxes on it.
What to invest in is way beyond the scope of what I am suggesting to you. I can only tell you what I did. I invested their Roth money into the Vanguard S&P 500 mutual fund and Vanguards Total stock market ETF. When my kids got older (they are now in their 30s and 40s), they diversified into other mutual funds and ETFs. Nevertheless, the annual $7,000/year contributions are now worth hundreds of thousands of dollars.
Time is on their side. Not only are you booking them an early seat aboard the retirement train, but you are also helping them develop lifelong habits (of saving and investing) that will stand them in good stead as they pass into and through their working years. This may be the best gift you ever give them.
Send your thoughts and comments to Myron who will post in a Friday reader response.