Opening a Roth IRA is the biggest thing you can do to give your child (or your grandchild) a head start on their path to financial independence. The money deposited today has the potential for 50-60 years of tax-free growth. You can open the Roth IRA for them at Fidelity. As the adult, you control the account until age 18, even if it’s in the child’s name. (It does have to be registered with their social security number.) At age 18, the account is theirs, so don’t tell them about the account until later if they are not good with money. Just think of that extra 18 years of compounding before they even reach adulthood!
The Only “Rule”
A child must have their own earned income. They are able to contribute exactly what they’ve made, up to the annual limit. They do have to file a tax return, and you should carefully document the work they’ve done. You can give them an “offer letter” with their “salary” if you are hiring them for your family business to serve as documentation.
The money deposited can’t be an allowance or a gift. It’s up to you (or the child) to document the work, pay any taxes if applicable (although remember that the taxes are minimal, if any, which is the entire point of contributing at a young age) and it has to be a reasonable rate. ($500 an hour for shredding papers, no. $15 an hour for landscaping, ok.)
You can pay them solely by making deposits into their Roth IRA, you can give them their pay and deposit the same amount into the Roth IRA on their behalf, or you can give them their pay and match a portion of what they save. Any combination that you feel helps you teach your kids the value of money.
Babysitting, pet sitting, dog walking, shoveling snow, washing cars, yard work (lawn mowing, planting flowers), office work (mailing, filing or shredding papers, cleaning or taking out the trash), some house work (decorating, repairs, not just chores), modeling, and/or helping with a family business. I can guarantee my future two-year-old will be doing something.
What About Covering College Costs?
The standard advice for college savings is to open a 529 plan. However, there are multiple perks to investing in a Roth IRA first.
You can withdraw your contributions penalty-free at any time and for any reason. You’ll be penalized if you withdraw the earnings before turning 59 ½ unless it’s for a qualifying reason, but one of the qualifying reasons is paying for college! That’s tax free growth which could potentially cover college costs.
Money in a qualified retirement plan account is not reported as an asset on the Free Application for Federal Student Aid (FAFSA). A Roth IRA is a qualified retirement plan, but a 529 is not. A 529 plan will be considered an asset by FAFSA, so your child will probably be offered more loans and less scholarships if they have a lot of money in their 529 plan.
Most 529 plans have specific things you can or cannot invest in, and they often come with higher fees. A Roth IRA can be opened anywhere and invested in low-cost index funds with very low fees, so your money has the potential to grow faster.
A Roth IRA gives you a lot of flexibility in what you want to do with the money in the long term. Your child might earn scholarships for college (which means their 529 plan money has to go to someone else), you might end up with extra money from a good stock market run and want to pay for college out of a taxable account instead to let the IRA money grow, or your child may skip going to college altogether and start the next Facebook! You never know…
The Benefit of Those Extra Years of Compounding
Assuming only a one time deposit of $5,500 and a simple 7% annual return, your child would have almost $270,000 more tax-free dollars in their account than if they were to make their first deposit at age 35.
Age Dollar Amount After a One-Time $5,500 Deposit
10 $10,112 $5,500
18 $17,373 $9,450 $5,500
25 $27,898 $15,175 $8,832 $5,500
35 $54,880 $29,851 $17,373 $10,819 $5,500
40 $76,972 $41,867 $24,367 $15,175 $7,714
50 $151,415 $82,360 $47,934 $29,851 $15,175
60 $297,855 $162,014 $94,293 $58,721 $29,851
If you and your child keep adding $5,500 every year, the difference is over 4 million dollars COMPLETELY TAX FREE between starting as a child and starting at age 35.
Age Dollar Amount When Depositing $5,500 Annually
10 $75,990 $5,500
18 $186,995 $65,879 $5,500
25 $347,870 $153,384 $56,429 $5,500
35 $760,303 $377,721 $186,995 $86,810 $5,500
40 $1,097,993 $561,402 $293,899 $153,384 $39,343
50 $2,235,909 $1,180,353 $654,134 $377,721 $153,384
60 $4,474,362 $2,397,923 $1,362,771 $819,024 $377,721
You don’t need to contribute the max for them to still benefit. Even a one-time $2,500 deposit still gives them a $120,000 tax-free head start over someone who starts investing at age 35. Some years you might be able to max out, and some years may be nothing, but remember that anything helps!
Age Dollar Amount After a One-Time $2,500 Deposit
10 $4,596 $2,500
18 $7,897 $4,295 $2,500
25 $12,681 $6,898 $4,014 $2,500
35 $24,945 $13,569 $7,897 $4,918 $2,500
40 $34,987 $19,031 $11,076 $6,898 $3,506
50 $68,825 $37,436 $21,788 $13,569 $6,898
60 $135,389 $73,643 $42,861 $26,691 $13,569