Roth I.R.A.s for Kids: First, Earn That Money

Has your teenager landed a summer job? Good! Now, consider putting your child’s earnings to work long term by opening a Roth individual retirement account.

It may seem odd to think about retirement savings when your child could still be wearing braces. But putting money now into a Roth I.R.A. means your child will have decades for the money to grow, tax free.

“Time is on their side,” Ed Slott, an authority on I.R.A.s, said of children with accounts. He opened a Roth for his daughter with a $350 contribution when she was 15.

A Roth I.R.A. is a special retirement account. Unlike a traditional I.R.A., a Roth doesn’t give you a tax deduction for contributing. Most teenagers, however, don’t make enough to pay much income tax, so deductions are less valuable to them. The money in a Roth can be invested, and it grows tax free and can be withdrawn tax free as long as certain rules are met. Roths also have income caps that may limit contributions as a child’s salary increases, so starting young makes the most of the account’s tax-free growth.

“The earlier you start, the more time your money has to grow and compound,” Carrie Schwab-Pomerantz, president of the Charles Schwab Foundation, said.

Many people don’t realize that there is no minimum age to open a Roth. “I do think it’s tremendously misunderstood,” said Cheryl Costa, a certified financial planner in Framingham, Mass., who opened a Roth I.R.A. for each of her three children when they turned 12.

Here’s what to know. Your child must have earned income to qualify. This means getting paid by an employer or for jobs like walking dogs and babysitting. (Money paid by parents for household chores is a gray area; more on that later.)

Most children aren’t likely to earn enough to make a large contribution on their own, and they may prefer to spend their earnings or save for shorter-term goals. “Convincing a child to hand over cash for retirement is especially difficult,” said Rita Assaf, vice president of retirement products at Fidelity Investments.

But the money contributed to the Roth doesn’t have to come directly from your child’s pocket. Parents — or grandparents — who can afford to help can match a child’s contributions or deposit the entire amount, up to the amount the child earned. So if a teenager earned $1,000 working over the summer, a parent could contribute $1,000 to the Roth. (The maximum total contribution is $6,000 annually for people under age 50.)

Susan Allen, senior manager for tax practice and ethics at the American Institute of Certified Public Accountants, said she had opened a Roth at age 16, with her father’s encouragement; he matched part of what she earned from working in retail and teaching ballet.

“I have every intent to do it with my own children, too, when they have earned income,” she said.

To help things go smoothly, keep documents showing that the contribution was valid in case of a tax audit, financial planners recommend. A child who receives a paycheck will get a W-2 form showing the earnings. If the money is from self-employment, it’s smart to keep a detailed log, noting the date, service provided and amount paid (such as “June 18, babysitting for the Smiths, $50”).

It may be helpful to have the child file an income tax return, Mr. Slott said, even if the income falls below the federal filing threshold. The return will document the earned income, he said, and can help with tracking contributions. Unlike contributions to a traditional I.R.A., contributions to a Roth I.R.A. (but not the earnings) can be withdrawn at any time, for any reason, without penalty, he said.

And note: A child who earns more than $400 in self-employment income after expenses may have to file a return anyway; consult a tax professional.

Most kids won’t earn much, but even a little can get the account started — and early saving can make a big difference over time. According to a hypothetical example from Fidelity, someone contributing $3,000 per year to a Roth from age 15 to 20, and then contributing the maximum allowed amount annually until age 70, could accrue more than $3 million, assuming an annualized return of 7 percent. The same person starting at age 20 would accumulate about a million less.

Roths also offer flexibility. In general, to avoid taxes and penalties, an account owner can’t withdraw earnings before age 59½, and the Roth must have been open for at least five years. But there are exceptions for early withdrawals for certain reasons, like a down payment on a first home or college expenses.

“Everyone’s situation is different and life throws curveballs, so it’s nice to know it’s an option if a rainy day happens,” Ms. Allen said.

Ms. Costa strongly discourages early withdrawals of funds designated for retirement since doing so cuts into the account’s potential for long-term, tax-free growth. “That’s a dagger to the heart for me,” she said.

Parents of a minor can open a Roth as a custodial account at most major brokerages. The parent manages the account on the child’s behalf until age 18 (or 21, in a few states). After that, control of the account shifts to the child.

Since children will eventually be in charge, it’s important to involve them in monitoring accounts and to have ongoing talks about the benefits of long-term saving and investing, advisers say.

“It’s encouraging them to save early and save often,” said Jeff Jones, director of financial planning at Longview Financial Advisors in Huntsville, Ala.

Here are some questions and answers about Roth I.R.A.s for teenagers:

How should funds in a teenager’s Roth be invested?

Funds in a teenager’s Roth may be invested fairly aggressively in stocks because the time horizon is so long, Ms. Costa said; there are decades to recover from market dips. A low-cost, total market index exchange-traded fund can be a good choice, she said. Target date funds, which automatically shift investments from stocks to bonds over time, are an option but generally have higher fees — and some may have more exposure to bonds than necessary for such young investors, she said.

Can payment for chores count as income for a Roth?

Opinion varies on this question, so you may want to consult a tax adviser. James Lee, a certified financial planner in Saratoga Springs, N.Y., said payment for chores could be considered earned income if the rate paid was “reasonable” and reflected what you would pay a nonfamily member.

“You can’t pay a child $6,000 to mow the lawn” and then make a Roth contribution based on that amount, he said.

Payment for a substantial task that would otherwise require you to hire outside help could qualify, Ms. Costa said. But, she added, “I wouldn’t count the chore money.”

Mr. Slott counseled caution: “It has to be legitimate and genuine work. You can’t pay kids to clean their room” and count that as income.

Will a Roth I.R.A. affect college financial aid?

That depends. The Free Application for Federal Student Aid, known as FAFSA, is used by most colleges to assess a student’s eligibility for financial aid and doesn’t ask about retirement funds — so money sitting in a Roth won’t affect aid. (Pre-tax contributions to some retirement accounts must be reported on the form as “untaxed income,” but Roth contributions are made after taxes, so they’re not included, Mark Kantrowitz, a financial aid expert, said.)

But withdrawing funds from a Roth to pay for college expenses could affect financial aid down the road because the distribution counts as income on a subsequent FAFSA, Mr. Kantrowitz said. To avoid this, he said, college students should time Roth withdrawals carefully; it’s generally best to wait until at least the second semester of the sophomore year to tap Roth funds for education expenses. (Why? Because the FAFSA for a given academic year uses financial information from two years earlier.)

The CSS Profile, a separate form used by some mostly private colleges to allocate school aid, does ask about retirement holdings to provide “contextual” information to schools. This information isn’t included in institutional need calculations, however, so “it does not impact a student’s financial aid eligibility,” said Jaslee Carayol, a spokeswoman for the College Board, which administers the profile.

However, Mr. Kantrowitz said that while retirement assets weren’t automatically included in the profile’s financial aid formula, they could affect aid eligibility at some colleges — especially if the family had what schools deem “excess” retirement savings.

“After all,” he said, “if retirement savings doesn’t have an impact on financial aid, why would they ask questions about it?”