What a pair: Your working teen and a Roth IRA
June 03, 2015
Many things may come to mind when you think of a natural pair: peanut butter and jelly, socks and shoes, baseball and summertime. A teenager and a Roth IRA? Maybe not so much. However, for teens just starting to earn some money, opening a Roth IRA—or, more likely, having one started for them—may be a good idea. Here are a few reasons why.
They're able to invest for the really, really long term
Opening an IRA for a teen
If you're opening an IRA for a minor you love, it will be considered a "custodial" account. The process is simple, but it can't be done online. You'll need to complete and sign a paper form.
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Time is one of the most powerful assets any investor has—and teens usually have it in abundance. The snowball effect that occurs when your investments generate earnings on top of earnings, called compounding, gets stronger over time.
So the earlier your teen starts investing, the more intense the effect of compounding can be. For example, if he or she starts at age 15, compounding can help every dollar contributed by age 60 earn more than twice as much as a dollar contributed at age 30, and more than 10 times as much at age 50. (For more on why graduating to an IRA is worth considering, read this article.)
They'll develop what ideally will become a lifelong habit
Developing the saving-for-retirement habit early can give additional oomph to the power of compounding. Vanguard research shows a 25-year-old who saved 6% of salary each year in a portfolio with a moderate mix of assets (50% stocks and 50% bonds) built up a median balance at retirement of about $359,000. Delaying saving until age 35—even when all other conditions were the same—resulted in a median balance about one-third lower, while waiting until age 45 resulted in a median balance about two-thirds lower.
"Starting a Roth IRA for a teen you love is a great way to get him or her engaged in investing," said Maria Bruno, a retirement expert with the Vanguard Investment Strategy Group. "And selecting the investments together can help your teen understand the principles of investing success—plan, balance, cost, and discipline—which will be building blocks for the future."
The feeling that there's something personal at stake now that your teen has some money invested also improves the likelihood you'll capture his or her interest in investing—and that interest may last a lifetime.
They'll be able to take advantage of their low tax bracket—and gain flexibility
Because you invest after-tax dollars in a Roth IRA and can make tax-free withdrawals when certain conditions are met, a teen's lower income—and lower tax bracket—can be an advantage. (To open an account at Vanguard, they'll still need at least $1,000.)
"Both traditional and Roth IRAs have their benefits, but Roths are especially advantageous for young investors because they are usually in a low tax bracket and can benefit from years of tax-free compounding. Additionally, Roths provide flexibility that's especially useful for young investors," said Ms. Bruno. "You can always withdraw your contributions without having to pay taxes or penalties, so if something comes up and you need to tap into your account, you can—although it's much better to leave it earmarked for retirement."
There are a few additional components that add flexibility for Roth investors. "Distributions are penalty-free for first-time home purchases up to a $10,000 lifetime maximum, as are postsecondary education expenses," said Ms. Bruno. These features can help make the Roth more versatile for young investors.
A word of caution
If you open an IRA for a teen, the IRA will be considered a "custodial" account. This means that you'll have control of the money in the account while your teen is considered a minor in your state. "Keep in mind that once young investors reach the age of majority, they can do whatever they want with their balance, including spending it," Ms. Bruno said.
You've heard the statement "All investing is subject to risk." In this case, one of the risks is that, once your teen reaches the age of majority (which varies by state), he or she may decide to use the IRA savings to buy a new laptop or other big-ticket item with whatever's left after paying taxes and penalties. But, given the long-term benefits of saving early and getting in the habit of investing regularly, it may be a risk worth taking.
- All investing is subject to risk, including the possible loss of the money you invest.
- Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
- The examples in this article are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.