Posted by Mike Abernathy
Many people may not be aware of the fact that teenagers may contribute to IRA’s. The only requirement to contribute to an IRA is the taxpayer must have earned income. Earned income is income derived from working, as opposed to investment earnings, which are not considered earned income. Annual IRA contributions are limited to the amount of the taxpayer’s earned income during the year and are capped at $5,500 for those under age 50. This means any teenager who works a summer job is eligible to contribute to an IRA. Teenagers have a few special circumstances which make the Roth IRA a particularly attractive investment vehicle.
Teenagers’ youth gives their retirement savings more time to grow than the rest of us have. Assuming a 7% annual return, if a 17 year old who plans to retire at age 67 makes a $5,500 contribution, that amount would grow to $162,000 by retirement. The same contribution made by a 27 year old would only grow to $82,000 by age 67. This early start amounts to roughly a doubling of the investment account balance by retirement age. Keep in mind investments held in an IRA grow tax free.
If a teenager’s only income was a part time job it is likely they would have a very small tax liability, if any, making the Roth IRA a much more attractive option than the Traditional IRA. The tax savings lost from the Traditional IRA deduction given up would be minimal. Also, Roth IRA distributions during retirement are not taxable, whereas Traditional IRA distributions are.
Since most teenagers live at home with their parents a large percentage of their income is likely to be disposable income. It is one of the few times in their life they will have the opportunity to save most of what they earn. Although they will have a much higher income later in life, setting aside a few thousand dollars may be more difficult to do once they are financially responsible for themselves.
Even if the teenager does not want to invest their money, a generous parent may choose to make a contribution on their child’s behalf. Parental contributions are permissible as long as the contribution does not exceed the amount of earned income the child had during the year.
For more advice on the most tax efficient savings vehicles for your goals, consult your tax advisor.