March 31, 2017

Roth IRA Graduation Present

Tip Content Provided By: Financial Finesse

Are you bored with giving your teenage child gift cards and electronics for presents? Do you have a graduation gift to offer but don’t just want to give cash? This year, instead of something they’ll spend right away, consider giving the teenager in your life a contribution to a Roth IRA.

A Roth IRA is an after-tax retirement account which can be used for much more than retirement. As long as the account has been open for at least 5 years, earnings and withdrawals are tax-free after age 59 ½.  Anyone who has earned income below certain limits ($118,000 for a single filer) can contribute the lesser of their total income or $5,500 in 2017.

Does your teenager work?

The key is that your teenager has to have earned income. A teenager with a part-time job could contribute their total earnings to a Roth. Gifts don’t count, but you and other friends and family can make gifts to your teenager to cover the allowable Roth contribution.

For example, if your teenager earned $1,500 working at a restaurant, she is eligible to contribute up to $1,500 to her Roth for that year. Remember — you can gift your teenager the money for the contribution, though. In fact, you could even write a check directly to their Roth account.

A W-2 from an employer is proof of income. However, if your teenager’s income comes from sources like babysitting or moving lawns, keep careful records of how much they’ve made. FYI, your teenager does not have to file a tax return in order to make a Roth IRA contribution but does need to keep a record of that contribution. If they have paid income taxes through payroll deduction, they may want to file, though.

Why give a teenager a retirement account?

1. Tax-free growth can help make them rich.

Let’s say you gift your teenager $500 for their Roth IRA as a high school graduation present. Those funds are invested in a diversified, low fee index fund which earns 8% per year. In fifty years, thanks to the value of compounding, that investment would be worth $23,451. (See calculation.)

Do that every year instead of giving a wrapped gift (or until they can take over contributing on their own). After 50 years, your $25,000 worth of gifts would be worth $310,336. (See calculation.) That’s much better than a new telephone, isn’t it?

2. They can withdraw contributions at any time without taxes or penalty.

A Roth IRA account holder can withdraw their original contributions – but not the growth – in their account at any time without taxes or penalty. If needed, they can withdraw those contributions later on to pay for graduate school, fund the down payment on a home, cover expenses while on maternity leave or even handle an emergency. The growth on the investments could stay in the account, continuing to grow tax-free for retirement. For more explanation of the withdrawal benefits, see this post.

3. It’s not counted on the FAFSA.

The Free Financial Application for Student Aid (FAFSA) does not consider a Roth IRA account as an asset the student (or a parent) is expected to spend. However, if your student takes a withdrawal of earnings from their Roth, those earnings are counted as income for the next year’s FAFSA. If you need to access earnings to pay college expenses, the key is to wait until the student’s final year to take the withdrawal. For more tips on how assets and income affect financial aid, see this blog post.

Are you convinced? The next step is to open a Roth IRA at a reputable, low fee financial services firm. (See suggestions here on how to choose one). If your teenager isn’t 18 yet, you’ll need to open the account for them. When your teenager is about to turn 18, make sure to share this guidance with them – and keep helping them contribute to their Roth IRA if you can!

Have a financial question? Send it to Ask Financial Finesse.

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