Teenagers’ retirement may seem too far off to warrant saving now, but IRAs can be perfect for teens precisely because they’ll likely have many years to let their accounts grow tax-deferred or tax-free.
The 2015 contribution limit is the lesser of $5,500 or 100% of earned income. A teen’s traditional IRA contributions typically are deductible, but distributions will be taxed. Roth IRA contributions aren’t deductible, but qualified distributions will be tax-free.
Choosing a Roth IRA is typically a no-brainer if a teen doesn’t earn income that exceeds the standard deduction ($6,300 for 2015 for single taxpayers), because he or she will likely gain no benefit from deducting a traditional IRA contribution. Even above that amount, the teen probably is taxed at a low rate, so the Roth will typically still be the better answer.
If the child is working to earn spending money or to save for college, you may be reluctant to encourage them to tie up their hard earned wages in a retirement account. In this case, you might want to consider gifting the money to your child to make the contribution. As long as they have earned income at least equal to the contribution, the source of the funds does not matter. A gift of tax deferred or tax free retirement security would probably be a good use of gifted funds.
How powerful can an IRA for a teen be? Here’s an example: Both Madison and Noah contribute $5,500 per year to their IRAs through age 66 and earn a 6% rate of return. But Madison starts contributing when she gets her first job at age 16, while Noah waits until age 23, after he’s graduated from college and started his career. Madison’s additional $38,500 of early contributions results in a nest egg at full retirement age of 67 that’s nearly $600,000 larger than Noah’s — $1,698,158 vs. $1,098,669!
In certain instances, the IRA can even be a vehicle for tax deferred savings for things other than retirement. Although there is typically a 10% penalty assessed for withdrawals made from an IRA before the receipient reaches 59 ½, there are exceptions to that penalty. The exceptions include funds withdrawn to pay qualified education expenses, certain medical expenses, or up to $10,000 to apply towards the purchase of a first home. Distributions from a traditional IRA will still be subject to regular income tax, but in certain cases, early withdrawals from a Roth IRA may be tax free.
Contact us for more ideas on helping teens benefit from tax-advantaged saving.
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