Once your child has earned income, he or she can invest in a Roth or traditional IRA and receive a tax credit from the feds.
Children who open an Individual Retirement Account (IRAs) with their first job get a jump start on saving for future expenses and get a tax credit through the IRS Credit for Retirement Savings Contributions.
Your 16-year-old son, who just started bagging groceries at the local supermarket, is years from retirement, but it’s never too early to start saving, even through an IRA. Here’s why:
IRS rules state that anyone with earned income—sorry, allowances don’t qualify—can open a traditional or Roth IRA. Currently, the IRS limits annual contributions to $4,000. Don’t worry about convincing Junior to stash his hard-earned salary in a retirement account. Anyone, including parents and grandparents, can contribute the money to fund the account, as long as the amount does not exceed your child’s earned income.
Not only will Junior get a head start on savings, he can receive a significant tax credit on his federal tax returns if his income is under $25,000 a year. Individuals earning less than $15,000 receive a credit worth half of the IRA contribution, up to $1,000. The credit is gradually decreased as income increases. Those earning between $15,000 and $16,250 receive a 20-percent credit, while individuals earning between $16,250 and $25,000 get a credit of 10 percent. The credit rules are slightly different for joint and head-of-household filers.
Scenario: Junior earned $5,000 last year from bagging groceries on the weekend at the local supermarket. He opens an IRA, into which his doting grandmother contributes $2,000. On Junior’s federal tax return, he earns a $1,000 credit (half of the $2,000 contribution), a full 50-percent return on investment!
At this age, opening a Roth IRA makes more sense, as the tax deductions from a traditional IRA are minimal for earners with low income. Also, Junior can withdraw contributions to a Roth IRA (not earnings) at any time for any reason tax free and without penalty. Also, withdrawals of Roth contributions and earnings are tax- and penalty-free if used to pay for higher education expenses or a first-time home purchase.
Of course, if Junior is the disciplined type, he could forget about this retirement account, or continue to add to it throughout his earning years. If so, he’s likely to have a significant nest egg at retirement. After age 59-1/2, all Roth IRA withdrawals held more than five years are tax-free. An account with $2,000 earning 8 percent interest over 50 years will be worth nearly $108,000 when Junior is ready to retire.
See more on Roth IRAs at Roth IRA for College Savings.
