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How would it feel to give your children a huge leg up in terms of saving up for retirement while helping them create healthy money habits?
The answer could be to open a Roth individual pension account for them.
To begin with, a Roth IRA is a special pension account that allows participants to receive tax-free income in retirement. There are no age restrictions; therefore, a child can have a Roth IRA account and get a good head start on both their retirement savings and wealth building goals.
It is important to know that a child must have some work income to contribute to a Roth IRA, but anyone can also contribute on behalf of a eligible child.
The IRS will consider earnings from a part-time after-school job or summer work experience as eligible to be invested in a Roth IRA. But savvy business owners can also hire their kids to help with filing, cleaning or other tasks that allow the owner to help their child get this huge leg up on retirement savings.
Here’s how Roth IRAs work
When your child adds cash to their Roth IRA account, they get no tax breaks – which in any case would not be valuable to them, as children’s tax rates are typically very low. However, the valuable tax benefits come at the back.
Your child will be able to raise their contributions and earnings 100% tax free when they are over 59½ years (based on applicable rules). Both the investment made and all the interest, dividends and growth on these assets escape Uncle Sam’s claws and will accumulate a nice pot of cash over time.
If your child needs access to the investment account in the past, they can withdraw their contribution tax and penalty free for any purpose if they have owned the account for at least five years.
Why Roth IRAs are Ideal for Children
Children have decades for their Roth IRA contribution to grow, tax-free. The strength of composition works by exponentially increasing the value of the account. First, all earned profits will be returned to the principal amount and then reinvested in the stock market to accelerate account growth.
A famous polymath, inventor, scientist and diplomat also praised the strength of composition over the course of his life. Benjamin Franklin commented: “Money makes money. And the money that money makes makes money.” Franklin’s definition of composition is perfect and why it’s powerful to save as much as you can at a young age.
The rule of 72
Although composition may sound complicated, especially if you do not have spreadsheet software, you can use a formula to perform these calculations in your head. The rule of 72 is a useful method of figuring out how long it will take to double your money.
To determine the amount of time to double your investment, divide 72 by the interest rate. For example, if your child invests in the S&P 500 Index and it returns 10% over time, it will double their investment value in the 7.2-year portfolio (72 divided by 10).
Even Albert Einstein was impressed with this mathematics. There is an often told story that when asked what humanity’s greatest invention was, he said, “The most powerful force in the universe is the rate of interest.” He referred to saving money and making it grow as one of the greatest “miracles” known by man.
How to open an IRA for a child
It’s pretty simple to open a Roth IRA for your child.
Schwab, Fidelity, E * Trade and many other companies offer custody Roth IRA accounts to your children. As a custodian of the account, you will control the funds in the IRA and make all investment decisions until your child reaches the age of majority.
In most states, the age of majority is 18, and others have a higher age of 19 or 21. When your son or daughter reaches the majority age as defined by your state, the Roth IRA is transferred solely to their name.
How to Fund a Roth IRA
A child of any age can save in a Roth IRA. But the work your child is doing should be age-appropriate with “reasonable pay.” Knowing what work income is is very easy with a job working for a company that will issue 1099s to your child at the end of the year.
However, the line may become blurred when your child works for you, babysits, mows or establishes their own business, such as a lemonade stand. Auditors agree that it is crucial to keep good records and invoices for work performed.
Parents can also help their child leave their Roth IRA savings by matching the contributions.
For example, if your child earns $ 2,000 at their local ice cream shop during the summer and saves half of that in their Roth IRA, parents can add up to $ 1,000 more to the investment account. The only problem is that your total contribution must not exceed your child’s earned income for the year. Also note that there is a maximum IRA contribution limit of $ 6,000 for 2022.
Building good financial habits
In addition to creating a well-padded retirement fund, your child will begin to develop healthy financial behaviors from a young age. Studies show that the earlier children learn about money and how it works, the better off they will be in the long run.
Unfortunately, you can not trust your local school to teach even the basics of good money habits. Very few states mandate the teaching of personal finance, and even fewer have qualified professionals who teach the material.
Saving up for a Roth IRA detention with your child is the best way to ensure that they will be financially secure and develop a genuine respect for the value of their money, today and in the future.
The bottom line is that Roth IRAs are ideal for children because children have decades of their contribution to growing tax-free.
– By Stacy Francis, President and CEO of Francis Financial