I have had a job as long as I can remember. At eleven years old I had my own paper route. Once I turned 16 I started working at a restaurant called The Spaghetti Bender. In undergrad it was delivering furniture for The Wicker Company. Working for me was a way to earn spending money so I didn’t have to bother my mom. Unfortunately, as I earned more I spent more. Initially it was cassettes then CDs then stereo equipment then skis and my last big purchase was a motorcycle in undergrad. Looking back I wish the Roth IRA had been in existence and someone had told me to throw a few bucks that way.
This past week I attended a session led by one of the preeminent estate planning attorneys in the US, Natalie Choate. Some of the material she covered included the best and worst retirement planning ideas. She was kind enough to also provide a packet with 203 of her best and worst ideas. I thought it was worth talking about her 101st best idea – Establish Roth IRAs for low-earning young family members. The timing seems perfect as school is out and many young people are working. My older son is once again working as a lifeguard at a local Y.
If you are not familiar with a Roth IRA, let me cover the basics. Contributions to Roth IRAs go in after taxes, so there is no immediate tax benefit. Growth occurs tax-free and distributions are tax-free since you have already paid taxes before the money went into the Roth IRA. There also are no required minimum distributions (RMDs) with Roth IRAs.
Ms. Choate’s specific idea is for older family members, whether it is parents, grandparents or great aunts and uncles, to use part of the annual exclusion gift to establish a Roth IRA for him or her. Unless your teenager is a child actor or YouTube star, their work income will easily fall under the income limit of $118,000 to $133,000. The maximum contribution amount for someone under 50 years of age is $5,500 or the child’s compensation, if less.
While people who are older and higher income earners can argue about the tax advantage of contributing to a traditional IRA vs a Roth IRA, for teenagers with low income there should be no argument. Most summer jobs will not pay enough that the child has any type of tax bill. For most the contribution to a Roth IRA is basically tax-free on the front end. So, you not only get tax-free growth and tax-free distribution, but also tax-free contribution. The only thing you miss is any type of tax deduction.
Now, there are two items to be aware of before going down this path. First, the Roth then becomes the child’s account and they can withdraw the money at will. Second, make sure the child has real “compensation.” Weekly allowance is not compensation, but slinging burgers at McDonald’s is.
Ms. Choate’s concept is to use the Roth as a tool for someone to gift up to $5,500 or the child’s compensation, whichever is less. So, if junior earns $3,000 dropping fries at Wendy’s and he has his eyes set on a car, maybe grandma or grandpa can agree to match his earnings with a $3,000 gift to a Roth IRA in junior’s name. This way the estate is reduced, the grandparents help to get junior off on the right foot for the future, and junior’s hard work is rewarded when he gets his used set of wheels. Regardless if funding a Roth IRA is based on Ms. Choate’s gifting strategy, Roths are still a tremendous planning option for younger people who have some income and haven’t spent it all on motorcycles.