Often, we are asked, “What is the best type of savings account for my teenager?” There are a handful of account types designed to benefit young adults whether it be for future college expenses, a down payment on a house, or an opportunity to start a positive habit of saving for retirement. These account types can include college savings plans, such as a 529, a savings account at the local bank, or even a custodial account in which the parent gives control to the minor when they turn 21. But don’t overlook perhaps the best account type for a teenager, a Roth IRA.
Tax Free Growth:
There are many benefits that come with opening a Roth IRA. Since contributions are made with money that has already been taxed, the growth accumulates tax free and may be withdrawn after the owner turns 59 ½ years of age. Unless the teen has a lucrative side job, they will pay little, if any, taxes on their earned income now. It is more advantageous to pay the minimal tax today and have the teen reap the benefits of a tax-free asset down the road. An important reminder is to invest the Roth IRA assets into the market. If this money is left sitting in cash or money market account earning minimal interest, the teen will miss out on this great benefit.
Any contributions made to a Roth IRA can be withdrawn at any time, without penalties or taxes. Typically, when funds are taken out of a retirement account, if the owner is under 59 ½ years old, a 10% penalty would be assessed for early withdrawal. In addition, the total amount would be counted as taxable income. With a Roth IRA, these stipulations do not apply to any contributions made to the account. If the teenager is gearing up for college and needs a new laptop, a withdrawal of any contributions made can be taken from the account. No penalties! However, any earnings need to stay until the teen reaches 59 ½ years old.
Advantageous for Financial Aid:
Another benefit with a Roth IRA pertains to FAFSA calculations. Money inside a Roth IRA is not included in FAFSA calculations when applying for student financial aid. If the money contributions had been put into a savings account instead, they would now count as a source of funds to pay for college expenses.
The maximum amount a teenager can contribute to their Roth IRA is currently capped at $6,000 a year, per 2020 IRA contribution limits. The funding can come from the young adult themselves, mom and dad, grandparents, or even a neighbor. The key factor to remember is the child must have earned income that is reported on an income tax return. Giving a teenager twenty-five dollars a week for cutting the grass typically does not count as earned income since they are not receiving a W2 in the mail. In addition, the amount of the contribution cannot be greater than the income reported to the IRS. If a contribution of $3,000 is made during the year, the teen must also have $3,000 or more of income reported.
Good Habits Start Early:
Parents can sweeten the deal for their teenager and offer their own “match” to encourage their teen to save more of their earned income. Instead of asking their teen to contribute a large amount of their babysitting money, perhaps match dollar for dollar to incentivize the teenager to save more.
Funding a Roth IRA early is typically one of the most advantageous financial decisions families can make. Between picking investments, encouraging saving, and monitoring performance, a Roth IRA will help teach a teenager many valuable life lessons about building wealth and personal finance.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.