Once your children start working, help them develop good savings habits by encouraging them to fund an individual retirement account (IRA). Even if your child only contributes for a few years, an IRA can provide significant funds for retirement.
Your child must have earned income to contribute to an IRA and may only contribute the lesser of earned income or the maximum IRA contribution. The maximum limit is $4,000 from 2005 to 2008 and $5,000 from 2008 to 2010. After 2008, the amount will be adjusted for inflation in $500 increments. Due to tax law provisions, the limit will be reduced to $2,000 in 2011 unless further legislation is enacted.
Assume your 16-year-old daughter starts working part-time. If she contributes $2,000 to an IRA from the ages of 16 to 22, she will contribute $14,000 over seven years. With no further contributions, the IRA could grow to $527,437 on a tax-deferred or tax-free basis by age 65. That assumes earnings of 8% compounded annually but does not include any income taxes that might be due.
If your child continues $2,000 IRA contributions annually until age 65, she would make total contributions of $98,000 and could accumulate investments of $1,145,540. (These examples are provided for illustrative purposes only and are not intended to project the performance of a specific investment vehicle.)
Although most children will be eligible to contribute to both a traditional deductible IRA and a Roth IRA, you should probably encourage your child to fund a Roth IRA, which has several advantages:
Roth IRAs are more flexible.
Your child can deduct all or part of his/her contributions at any time, without paying federal income taxes or penalties. Thus, if your child later decides to use contributions for college, a car, a down payment on a home, or for some other purpose, contributions can be withdrawn with no tax consequences.
Earnings accumulate tax-free, plus qualified distributions can be withdrawn tax-free.
A qualified distribution is one made at least five years after the first contribution and after age 59 1/2. There are also certain circumstances where earnings can be withdrawn without paying income taxes and/or the 10% federal income tax penalty. If your child allows the funds to grow until at least age 59 1/2, all contributions and earnings can be withdrawn without paying any federal income taxes.
A traditional deductible IRA offers little tax benefit to a child.
When your child first starts working, he/she will typically pay a low marginal tax rate on his/her low income. So even though the Roth IRA contribution is not tax-deductible, your child typically receives little or no tax benefit from deducting the traditional IRA contribution anyway.
If you can’t convince your child to use his/her own money to fund the IRA, consider reimbursing him/her, as part of your annual gift exclusion, for any IRA contributions. Hopefully, you will also teach your child some important lessons about saving at an early age.