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3 Reasons to Fund a Roth IRA for your Kids Thumbnail

3 Reasons to Fund a Roth IRA for your Kids

As parents, we all want to help our kids develop great saving habits. One way to do so is to help your kids save for retirement. Starting early and saving regularly is a recipe for long term success. Here are three reasons why you should consider starting a Roth IRA for your child or children. 

1.Tax-free growth (essentially) forever

To maximize the benefits of long term growth and compound interest, you can't beat the tax-free growth of the Roth IRA. Because you are funding the Roth IRA account with after-tax dollars, your child will not pay any taxes when she finally take funds out of the account in retirement. There also is no requirement for Required Minimum Distributions (RMDs) and you/she can continue to add funds to these accounts as long as she has taxable income to support the contributions. 

2. Flexibility (if you need it.) 

After 5 years of existence, the kids can remove any of their initial principal amount from the Roth IRA without taxes or penalties, but she will pay taxes/penalties on the embedded gains in the account. There are other exceptions that allow you to take the money out of the account without penalties prior to 5 years. Please make sure to confirm these details with your tax professional. Of course, the real reason for opening and funding the account is to get the benefit of tax-free growth. So, please don't take your money out early, unless you really need it. You can't get it back in once you take it out. 

If flexibility is the overriding concern, investing in a low-cost index fund in a taxable account is another option. This approach will not generate the same level of returns as compared to investing in the same fund in the Roth IRA as you will pay interim taxes and taxes on any capital gains generated on sales of the shares. But, starting a taxable account will give your children much more flexibility in case they want to use the money for other purposes in the future.

3. You can start at any age, if you have taxable income.

Kids of any age can fund a Roth IRA, if they have taxable income. If you run a family business, you can hire your children at a market rate for services rendered. I have fond memories of helping my parents (as a child) clean their offices and shred old documents. Since they were both CPAs, I also remember playing with their calculators and stealing a lot of Pentel pencils. I didn't realize how much those pencils cost until much later. Any earnings up to the current $6,000 maximum ($7,000 if over 50) can be contributed to the Roth IRA account, subject to earnings limitations. You or your child will pay taxes on the wages earned, but it is a small price to pay for the potential benefit of tax-free growth over half a century or more. 

There are a couple of things to keep in mind: 1) you can only contribute funds, up to $6,000 per individual, to the extent that they have sufficient taxable income for the year, and 2) there are income limitations on the contributions, so if they earn too much, and/or are covered by a qualified retirement plan at work, there may be a limit on what they can contribute. Roth IRAs are a great savings device and could be a great investment for your children. Please check with your CPA or tax professional to make sure it is set up and funded correctly if you go down that route. There is no reason why you can't include low-cost index funds in the Roth IRA, thus benefitting from the tax-free growth of the account and low expenses.