Does your teenage or college age child work part-time? If so, one of the best things you can do as parents is to encourage them to start saving money. Saving money from a job — rather than spending it — teaches discipline, responsibility, and the value of hard work. But what type of an account should you have your child invest in?
One choice, which is probably not on the minds of most young people, is a retirement account such as a Traditional IRA or Roth IRA. Granted, retirement is a long way off for your child, but the sooner they start saving for retirement, the more they will have later in life — which could allow your child to retire earlier.
The benefit of a Traditional IRA contribution is that amounts contributed are tax-deductible. Earnings grow tax-deferred. When withdrawals are taken from the account, the entire account balance is subject to income tax at their tax rate in the year the money is withdrawn.
A Roth IRA is different in that an upfront tax deduction is not taken for any contribution made to the account. The earnings grow tax-deferred. Withdrawals made by the child once he or she reaches age 59½ are tax-free. This can be a big advantage if the child, when needing to take withdrawals from the account, would otherwise be in a high tax bracket.
Usually the decision to do a Roth or a Traditional IRA comes down to a trade-off between paying income taxes now vs. paying them later.
However, for anyone whose taxable income is below a certain amount ($12,000 in 2018), the Roth IRA makes more sense. This is because if they qualify, their federal tax is zero. So making a Roth contribution won’t result in them paying any additional tax.
Making a Traditional IRA contribution won’t result in a tax deduction. However, it will result in the individual paying income tax on any amounts withdrawn in the future. This is not the case for withdrawing funds from a Roth IRA if done after age 59½. Therefore, not choosing the Roth could be quite costly when it comes to taxes.
Here is an example:
While Joe was in college, he earned $12,000 per year and was able to save $5,000 per year in a retirement account. He had no other taxable income. He did this for four years and then stopped. Assuming the money earns 7% per year, at age 60 Joe’s account balance will have earned $270,000 and will be worth approximately $290,000. If Joe saved the money in a Traditional IRA account, then all the withdrawals from the account would be subject to income tax, even though no income tax benefit was derived from his contributions into the account. If Joe had made the contributions to a Roth IRA instead, all the withdrawals from the account would be tax-free. Plus, he never would have paid any income tax on the amounts contributed since his taxable income in those years was low enough so he was not subject to income tax.
The Roth IRA continues to make sense even if your child’s taxable income exceeds $12,000. This is because the next $38,000 of earned income would be taxed at approximately 11.5%. So $5,000 contributed to a Roth IRA instead of a Traditional IRA still only costs approximately $600 of Federal tax.
Once your child starts to earn substantial income, he or she will need to make some decisions about how much they can contribute and whether they should contribute to a Roth or Traditional IRA.
As for now, the choice is clear. The Roth IRA wins.