IRAs for teens

Few teenagers think much about retirement, but funding an Individual Retirement Account may be one of the best financial steps they will ever take. The reasons are simple – taxes and time.

IRAs can be established by individuals of any age. The only requirement is that they have earned income equal to or exceeding the amount they contribute to an IRA. Contributions to Traditional IRAs can be tax deductible, but most teens have low enough incomes that much of their income is not subject to tax; or if it is, the tax rates are low. Roth IRAs are especially attractive for younger individuals because they offer the potential to accumulate funds that, if handled properly, will never be subject to income taxation.

Basic Rules for Roth IRAs

  • Contribution Limits
    You must have wages (or other earned income) equal to or greater than your contribution

  • Deductibility
    Contributions to a Roth IRA are not deductible

  • Earnings within the Roth IRA
    Earnings on the funds within the Roth IRA are not subject to income tax. This enables your funds to grow faster than they would in a taxable account

Distributions from a Roth

The significant advantage of a Roth IRA compared to a Traditional IRA is that distributions from the Roth IRA are not subject to tax provided you meet certain rules. Generally, if you take distributions after reaching age 59 ½, they are tax free. In addition, there are some rules that allow for distributions earlier if the funds are used for first home purchases or qualified education expenses.

As with most income tax issues, the actual rules can be complex. You may want to consult with your tax advisor for more details.

Putting Time on Your Side
The longer the funds remain in a Roth IRA, the larger the balance can become. For younger individuals, this can be very significant. Consider these scenarios:

Let's assume Sue has a part-time job for her last two high school years and contributes $3,000 in those two years. With the money earning each year and those returns compounding, the rate of earnings has a huge impact on what the balance grows to when Sue reaches age 60.

Total Contributions Accumulated Value at age 60 at different growth rates
  0.25% 2% 4% 6% 8%
$6,000 $6,705 $14,484 $34,373 $80,250 $184,429

Now assume she continues to work part time while going to college for four years and contributes $3,000 for each of those years.

Total Contributions Accumulated Value at age 60 at different growth rates
  0.25% 2% 4% 6% 8%
$18,000 $20,015 $41,786 $95,535 $215,238 $478,109

Putting This to Work
It is easy to establish a Roth IRA. Just visit your financial institution. You may even want to consider giving the child money for their contribution. Just remember that the individual must have wages at least equal to the contribution.

What a wonderful way for a young person to start on the road to financial security and to start a saving pattern that will provide returns for the rest of his or her life.

As with any investment plan, please contact your tax advisor for questions on how the plan might affect your taxes.