ROTH IRA’s: Working Teens Welcome

By Lynn N. Duke

NYT Regional Newspapers

As vacation time winds down and teens head back to school, many spend their summer earnings on the latest gadgets, clothes and even a few necessities like books. But what if they could secure a significant part of what they will need for retirement simply by socking away a good chunk of that summer income?

More than 43 percent of Americans in the 16-19 age group work full or part time, according to the U.S. Department of Labor Bureau of Labor Statistics, which means almost half of the future workforce can get a head start on retirement.

But first they have to prioritize their finances, because it’s not cheap being a teen these days.

“This generation of young adults is dealing with more money issues than any other before them,” said Todd Romer, executive director of Young Money magazine. “They have cell phones, student loans, credit cards, gas, car insurance, technology….”

And don’t forget about Starbucks.

But by putting away $4,000 each year for three years, leaving it there for 50 years and assuming an average 10 percent annual return (the stock market’s historic average over the past 70 years), this year’s high school freshmen will have $1.5 million when they turn 65. That translates to roughly 75 percent of what they will need in order to have 25 years of income comparable to today’s average U.S. earnings of $40,000 (adjusted for inflation). And that $1.5 million does not include any other retirement accounts they’ll establish throughout their professional careers, or government programs, like Social Security. Cut the initial investment in half, to $2,000 per year, and the account should still come in around $750,000.

“Kids who tend to pick up this habit, they stick with it,” said Eva Rosenberg, publisher of TaxMama.com, who is also an enrolled agent representing clients in front of the IRS. “It’s great for kids to learn how to manage their money and take responsibility for their future.”

Most teen employees don’t have access to a 401(k) retirement plan, but they can open an independent retirement account – either traditional or Roth – so long as their parent or guardian signs on as custodian. If they’re 18 or older, they can open an account on their own. Since most teens are in the lowest tax bracket they’re ever likely to see, a Roth IRA makes more sense, since the money is taxed going in but not coming out.

And for teens whose net income is less than $4,400 annually, they’ll pay no income tax making their Roth IRA contribution completely tax free, Rosenberg said.

But there’s the rub: In order to open an IRA, you must file an income tax return, even if there’s no tax due. Technically, anyone earning more than $400 per year has to file a return, Rosenberg said. But plenty of kids, who make that and more, either babysitting or mowing lawns, skirt this rule without consequence.

If you draw a regular paycheck and get a W-2, it’s probably in your best interest to file a return, not just legally, but because any taxes taken out may come back as a refund. And anyone earning less than $25,000 annually can file their return online for free, Rosenberg said.

In order for “off the books” income to qualify for an IRA contribution, you have to keep good records including the service you performed, when and how much you earned. And Rosenberg warns parents not to get too creative: Putting a T-shirt on your toddler to advertise your business, thus making the child a marketing tool and earning compensation, probably would not pass muster with the IRS.

Paul Sanchez, a Certified Financial Planner with Sanchez & Zures in McLean, Va., said despite the magic in the numbers, Roth IRAs for teens are not common. Part of the problem, he said, is the high rate of financial illiteracy in the U.S.

“A lot of very smart people come out of high school and college financially illiterate,” Sanchez said. “Financial planning, basic consumer economics, by-and-large, are not taught in this country.

“But if you can get high school students to put away $25 a month, $50, anything you can do, they’ll be shocked at how much accumulates. And by coaching them now, by the time they have a career, that savings discipline is set in place. Kids are more sophisticated now. If they’ll give you the time, more often than not, they’ll see this as a great idea.”

Contributions to a Roth IRA are capped at $4,000 annually for anyone under 50. However, contributions to a Roth IRA cannot exceed actual earned income. So what if your teen wants to max out a Roth IRA contribution, but also needs money for car insurance, a car payment or maybe just that to-die-for Juicy Couture velvet hoodie?

Parents, or other adults, can help. They can contribute as much as they want to their child’s Roth IRA, so long as it doesn’t exceed the maximum contribution allowed or total earned income. If your daughter earns $2,500, that’s the most that can go into the Roth IRA. And if she earns $5,000, that year’s contribution is capped at $4,000.

There is at least one potential downside to a teen’s Roth IRA. If they apply for financial aid, the value of their IRA will be taken into account when their aid eligibility is calculated, Rosenberg said. But this is true of other assets as well, including savings accounts, trusts and other brokerage accounts. But it’s not all bad news. Once contributions have been in the account at least five years, money can be withdrawn penalty free for several reasons, including higher education costs and buying a first home. Although there is no penalty on these early withdrawals, there are tight restrictions on their use, and there is a tax liability on withdrawals before age 59 ½, according to the IRS.

Parents making contributions to a child’s Roth IRA should monitor the account and make sure that the total contribution (from all sources) does not exceed the account’s guidelines. Excess contributions and any earnings they might accrue are subject to taxes and penalties, so check with the IRS and an accountant if this situation arises, Rosenberg said.

Setting up a custodial account is not complicated, but not all brokerage firms offer them so you will have to shop around. But it’s worth it, said Teen Money’s Romer, for more reasons than just the bottom line.

“When they see that money build, it makes them think twice about where they spend it,” Romer said. “It gives them a whole different mental attitude about how they spend their money.”