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ONE WAY TO MAXIMIZE long-term family wealth is through a teenager’s summer or after-school job. How do these small paychecks add up to serious money? Probably the best investment we can make for our children and grandchildren: Stash their earnings in a Roth IRA.
A teenager’s Roth has three things going for it: little or zero taxes owed on the small bits of income earned, 70 or 80 years of investment compounding, and zero taxes owed when those gains are withdrawn.
As Warren Buffett said, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.” Parents or grandparents who help children make Roth contributions can set up these kids to capture the third part of Buffett’s wealth equation—compound interest—on a tax-free basis.
To get started, a child must have earned income, such as wages or tips, to contribute to a Roth. I know some folks with family businesses who set their kids up to “earn” a paycheck. They might manage inventory, work the website, or help with marketing and shipping activities.
The maximum IRA contribution in 2021 and 2022 is $6,000 for those under age 50. Unlike a traditional IRA, Roth contributions are made with after-tax dollars. But Roth withdrawals are tax-free, providing the account is held for at least five years and the account holder reaches age 59½.
Some people might be scared away by the requirement to lock up their kids’ money for such a long time. They shouldn’t be. Roth owners can withdraw their contributions at any time. No taxes or penalties are owed, provided the account’s investment earnings aren’t withdrawn.
Since the account has decades to grow, I’d suggest a 100% allocation to low-cost stock index funds. Our daughter’s initial Roth contributions have generated about a 250% gain. She’s in her late 20s—with decades of additional compounding ahead of her.
A word of caution. I started putting the maximum amount in my son’s Roth IRA in the year 2000. By 2012, it was approaching $100,000. However, an ugly divorce and ongoing custody battle started in 2010. My son gradually pulled all of the money out to my great disappointment. It was good that it was there and I suppose good that it could be withdrawn. However, failure to file taxes appropriately during this terrible time created a huge snafu. I do not know what the moral of this story is. A Roth IRA is a wonderful vehicle but maybe it is equally important to educate your children on the miracle of tax-free money and compound interest in hopes that they will try to refrain from undoing everything you try to do.
Another piece of advice. Keep copies of every check that you deposit into your children’s accounts in the event you have to go to a divorce divorce proceeding and prove that the Roth IRA is separate property. Of course, you also have to remind your children not to put any of their own money into that Roth IRA but set up a separate one when they begin putting their own money into a Roth. This will provide protection in the event of a divorce down the line.
As soon as my children had jobs, I painlessly withheld from their paychecks by letting the IRS do it (defaulting their W4 as if they would work full time). Then I deposited their refund in an IRA. I also offered a “company match” by doubling the deposit. By the time they graduated college, they could already see a real illustration of the importance of compounding and of taking advantage of the company match.
Thanks for the interesting piece, John. Roth 401(k) and HSA plans are other potentially great savings vehicles for your daughter.