As summer comes to an end, many teenagers are flush with cash from summer jobs. If your teenager is in this situation and you’d like to use this opportunity to teach them the magic of compound interest, consider opening a Roth IRA for them.
Roth IRAs are a great investment vehicle for kids because the earlier they start saving in a Roth IRA, the longer they have for their money to compound tax-free. Furthermore, kids’ income is usually low enough not to worry about the income limits on contributions that eventually prevent many adults from contributing to a Roth IRA.
As a reminder, a Roth IRA is a great vehicle for saving for the future in a tax-free manner. Contributions don’t qualify for the tax-deduction of a Traditional IRA contribution, but growth is tax-free, as are distributions in retirement. An added benefit (but one I wouldn’t necessarily advertise to a child I was encouraging to save in a Roth IRA for the long-term) is that contributions can be withdrawn tax- and penalty-free after the account has been open for at least 5 years.
To be eligible to contribute to a Roth IRA, your child needs to have earned income from a job, so you can’t open a Roth IRA for your child and contribute to it until they start making money from employment and have their own earned income. While odd jobs like babysitting and pet sitting can count, it might be easiest to wait until your child has a job that generates a W-2 or 1099 so that you have documentation of their earned income. Otherwise, you’ll need to maintain a detailed spreadsheet of their odd jobs. As with all tax-related issues, consult your CPA or tax preparer to see what they recommend.
Your child can contribute up to the total amount of their earned income or $6,000 in 2022, whichever is less. While many parents might be tempted to contribute to the Roth on their child’s behalf and let their child keep their job money to spend, I think this approach misses a vital teaching moment about building a good saving habit early on. Instead, I’d recommend offering to match your child’s contribution from their own money with some of your own (e.g., maybe dollar for dollar), to incentivize them to start building a habit of saving their own money for the long-term. If your child is struggling to know how much of their earnings to contribute to the Roth, you might introduce them to the 50/30/20 rule of thumb for budgeting, which states that 50% of your income should be allocated to needs, 30% to wants and 20% to savings or other financial goals.
In terms of how to invest the money, that topic could be a whole separate article. A low-cost, diversified index fund or exchange-traded fund (ETF) that invests in stocks is always a good place to start. Some teenagers are interested in investing and may want the intellectual stimulation of learning about individual companies and picking their favorite stocks. The important point is to help your child invest the money in something that is likely to grow over the long-term and not just leave it sitting in cash, which is losing money to inflation every day, especially these days!
Parents of teenagers with summer job income have a golden opportunity to teach their kids about the magic of compound interest by building an early habit of saving a portion of their paycheck for their future. A Roth IRA is an excellent account to maximize the tax-free growth of those savings. It can also be an opportunity to teach them fundamental investing concepts. Seize it!