Roth IRAs for teenagers

In short

A friend of mine once said the best gift he got as a teenager was a small account that grew while he slept. You may be thinking about the same gift for a young person you love. A Roth IRA is a retirement account you fund with money you have already paid tax on. A teen can only put in money that equals what they earned from a job, and never more than the yearly limit of the current figure, which the official source publishes each year. A parent can give the cash, but the teen must have earned at least that much. Because the account is a Roth, growth and qualified withdrawals come out tax free. Opening one takes about an hour, and a custodian, who is an adult that manages the account for a minor, handles the paperwork.

The whole of it

What it is

I once watched a boy mow lawns all summer and then stare at his cash like he did not know what to do with it. If you are holding a similar picture in your mind, a Roth IRA may fit. It is a retirement account with one special feature. You pay tax on the money now, and after that the growth is not taxed again. Qualified withdrawals in retirement come out tax free too.

Why does this suit a teenager so well? Most teens earn little, so they sit in a low tax bracket. Paying tax now costs them almost nothing. The money then has decades to grow. Time is the quiet partner here, and a teenager has more of it than anyone.

A Roth IRA is not a savings account, and it is not a college fund. It is built for the long haul. You can take your own contributions back out at any time without tax or penalty, since you already paid tax on them. The growth is a different story. The IRS treats early withdrawals of growth differently, and Publication 590 B explains how.

How it works

You have probably heard that a Roth IRA needs earned income. That is true, and it is the rule people trip over most. Earned income means pay from a job, or profit from work done for yourself. Wages from a job at the pool count. Money from babysitting or lawn mowing counts too, if it is real work for real pay. Gifts, allowance, and interest do not count.

The teen's contribution cannot be larger than what they earned that year. It also cannot be larger than the yearly limit. Whichever number is smaller sets the ceiling. A teen who earned 2,000 dollars can put in at most 2,000 dollars, even if the limit is higher.

Here is the part that surprises parents. The money does not have to come from the teen's own paycheck. A parent or grandparent can give the cash. The teen just needs to have earned at least as much as goes into the account. So a teen who earned 3,000 dollars could have 3,000 dollars deposited, and the gift could cover all of it.

Because a minor cannot legally open an account alone, an adult opens a custodial Roth IRA. The adult manages it until the teen reaches the age of majority in their state. After that, the teen takes over. Many banks and brokerage firms offer these accounts. You pick a provider, fill out a form, and link a bank account. It is plainer than most people expect.

The numbers, and where to find yours

Numbers matter here, and they change. The yearly contribution limit is the current figure, which the official source publishes each year. The IRS sets it and can change it from year to year, so check the current figure before you deposit anything.

Income limits for Roth IRAs exist, but a teen with a summer job is nowhere near them. The phase out range is where the right to contribute shrinks for higher earners. It is set by law and listed as the current figure, which the official source publishes each year. Teens with summer jobs seldom come near it.

One more figure counts. The rule for taking out growth early has an age, the current figure, which the official source publishes each year. Before that age, taking out earnings can bring tax and a penalty. The penalty rate is set by law, and the current figure is the current figure, which the official source publishes each year.

Where do you find all of this? The IRS publishes it. Look at IRS Publication 590 A, called Contributions to Individual Retirement Arrangements, and IRS Publication 590 B, called Distributions from Individual Retirement Arrangements. The IRS website also posts a yearly page on retirement plan limits. These are the official sources, and they beat any blog, this one included.

A worked example

A neighbor of mine, a good woman named Carla, has a daughter named Maya. Maya is sixteen. Last summer she worked at an ice cream shop and earned 3,200 dollars. Carla wanted to help her start a Roth IRA.

First, Carla checked the ceiling. Maya earned 3,200 dollars. Suppose the yearly limit were 7,000 dollars for this example. The smaller of the two numbers is 3,200. So Maya could contribute up to 3,200 dollars that year.

Carla chose to deposit 1,500 dollars of her own money into a custodial Roth IRA in Maya's name. Since 1,500 is less than 3,200, it was allowed. Maya's earnings covered it with room to spare.

Now watch what time can do. Suppose that 1,500 dollars grew at 6 percent a year for 45 years. This is only an illustration, and it promises nothing. The math is 1,500 times 1.06 raised to the 45th power. That power comes to about 13.76. So 1,500 times 13.76 is about 20,640 dollars. Maya would have put in 1,500 dollars, and the account could grow to over 20,000 dollars. Withdrawals would be tax free if the rules are met.

Real markets do not grow in a straight line. Some years go up and some go down. The figure above shows how time can work, and nothing more. Still, the picture is worth a look.

Where it goes wrong

I have seen good intentions go sideways more than once. The first trap is contributing without earned income. If Maya had earned nothing, no one could put money in her Roth IRA. Kids who only get an allowance do not qualify.

The second trap is putting in more than the teen earned. Go over the line and the IRS charges a yearly tax on the extra until it is fixed. Publication 590 A explains how to fix it. Read that section before doing anything else.

Third, sloppy records. If a teen is paid in cash for odd jobs, keep a simple log. Write the date, the job, and the pay. If the IRS ever asks, that log is your proof. A teen who works for a family business should be paid a fair wage for real work, not a made up number.

Fourth, treating the account like a checking account. Pulling out growth early can bring tax and a penalty, as the section above described.

Last, a gentle word. A Roth IRA is one good tool among several, and it is not built for every family or every stage of life. You know your household best.

Questions to answer before you leave this page

Has your teen actually earned money from real work this year, and do you have a record of what they were paid? Do you know the current yearly limit, and have you checked it against the IRS page rather than trusting a number someone told you? Who will be the custodian, and are they ready to keep an eye on the account until your teen is old enough to take over? Will the money come from your teen's own pay or from a gift, and does the total stay at or below what they earned? Have you talked with your teen about why this money is meant to sit and grow for a long time? And have you looked at IRS Publication 590 A yourself, so that you feel sure about the rules before you open anything?