Consider this example: If a child invests $2,000 in a Roth IRA each year from ages 13 to 17, that $10,000 could increase in value to almost $296,000 by age 65, according to research by T. Rowe Price. That assumes the account earns a 7% annual rate of return. If that panned out, the account could provide tax-free income of $11,800 a year for 30 years.
Tax-free compounding of earnings inside an IRA is a beautiful idea — and a powerful one. The longer you can keep your money invested in a tax-free vehicle, the greater your wealth accumulation. What better way to accumulate a large amount of savings than to start during childhood? When tax-free compounding has more than 50 years to run its course, a relatively modest savings plan can produce substantial wealth.
There’s no minimum (or maximum) age to set up a Roth IRA. And there’s no requirement that the same dollars that were earned be used to fund the IRA. If your child earned money on a summer job and spent it on whatever kids spend money on these days,* there’s nothing wrong with using money provided by parents to establish the IRA. The child has to have earned income, though.
The major impediment to IRAs for children, especially young children, is the earned income requirement. An unmarried person must have earned income of his or her own to contribute to a Roth IRA. The income has to be compensation income, not investment income. And it has to be taxable compensation income.
That doesn’t mean your child has to actually pay tax on the income. If the total amount of income is small enough so your child doesn’t have to pay tax, that’s okay. But your child has to have the kind of income that would call for a tax payment if the amount were large enough.
Arie J. Korving, a CERTIFIED FINANCIAL PLANNER™ professional, has been delivering customized wealth management solutions to his clients for more than three decades. Prior to co-founding Korving & Company, he was First Vice President with UBS Wealth Management and held management positions with General Electric.