Do your teenage or college age children 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 children invest in?
One choice, which is probably not on the minds of most 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 you start saving for retirement, the more you 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taken from the account, the entire account balance is subject to income tax at the tax rate in the year the money is withdrawn.
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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 59 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 single taxpayers, whose taxable income is below a certain amount ($12,000 in 2018), the Roth IRA makes even more sense. This is because their income is low enough that their federal tax is zero. So making a Roth contribution won’t result in them paying any additional tax. Here is why:
Making a Traditional IRA contribution when your taxable income is already below the threshold amount at which you would owe tax won’t help you reduce taxes any further. So no advantage is gained when the contribution is made.
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What it will do, unfortunately, is set the account up for tax on withdrawals made in the future, since only a Roth IRA account allows for tax free distributions. Therefore, in this case, not choosing the Roth could be quite costly tax wise.
Here is an example:
While Joe was in college, he earned $12,000 per year and was able to save $5,000 a year in a Traditional IRA. He had no other taxable income.
Each year when he filed his income tax return he reduced the $12,000 by $5,000 (his retirement plan contribution) and paid no federal tax. What he did not realize was he was not receiving any additional tax benefit for the $5,000 tax deduction since he would have paid no income tax even if his taxable income was $12,000. He did this for four years and then stopped.
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Fast forward 39 years and Joe is now 60 years old. He has invested well, earning 7% per year in his Traditional IRA account, which is now worth $290,000.
If Joe wants to start withdrawing money from the IRA account he will have to pay income tax on everything he withdraws since the account is a Traditional IRA.
What Joe should have done is made those $5,000 contributions to a Roth IRA instead. His tax would have been the same (zero) during the four years he contributed. The account value would have been worth the same $290,000 as well (assuming he invested it the same way as the Traditional IRA).
But, all his withdrawals would have been tax free since it was invested in a Roth IRA.
The Roth likely makes sense in other situations as well even those where foregoing the tax deduction a Traditional IRA would get you would cost you more in upfront taxes.
But for your children, that decision could still be years away. For now, why not make the easy choice and have them contribute to a Roth IRA? You may even want to help them afford to contribute by helping them fund the account. That’s the deal I offered my 16-year-old son.
Howard Hook is a Certified Financial Planner and CPA with the wealth management firm of EKS Associates in Princeton, N.J.
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