Roths for Teenagers?

1040 March is just around the corner, which means we are entering the heart of tax season. Time to gather those 1099s, fire up the old TurboTax, and wonder how we can possibly pay Uncle Sam less money next time.

So ’tis the season to think about, and write about, schemes and tricks to minimize your tax bill. For example, the AP ran an item the other day discussing the rather unlikely maneuver of teenagers opening Roth IRAs.

It’s an idea with some intuitive appeal. As readers of this blog know, Roths are attractive if you believe that the tax rate paid today is likely to be lower than what will be paid when the money is withdrawn from the IRA. A teenager with a tiny income, and thus a low marginal tax rate, certainly qualifies.

And there is the tremendous emotional appeal of "the magic of compounding" that miracle of mathematics that will drastically increase the IRA balance during the very long journey to retirement. Even with only 5% annual return, after 50 years $1 would grow to $11.46. Imagine how grateful your child will be when they retire and realize the foresight you had in making them save way back in 2010.

Of course, there are some complications. Although there are no lower bounds on the age of a person opening or contributing to an IRA, a newborn baby could, in principle, do it, contributions cannot exceed a person’s earned income. So the kid in question has to actually make the money himself in a job of some kind. Investment income doesn’t count. (And is in any case taxed at the parent’s rate, which takes away much of the attraction of a Roth.)

And the child has to earn the money in a real bona fide job, preferably with W-2s and/or 1099s. The youngster has to file taxes just like a grown-up and pay Social Security and Medicare taxes. You can hire your kid yourself, but you would need to be prepared to demonstrate to an IRS auditor that it was a real job that involved real work and that you paid a reasonable wage for it. (No paying Junior $5000 to wash your car once a month.) More importantly, payroll taxes would have to be paid on the child’s income, so if your only goal is to stash some cash in your child’s Roth this is a poor idea.

But many high schoolers do have real part-time jobs, as grocery baggers, waitresses, lifeguards, runway models, etc. You don’t need to force them to save this income. You can give them the money to put in an IRA, it just can’t be more than they earned.

So is this a good idea for you and your kid? My answer is possibly, but not likely.

Young people generally do not save a lot. There are those who attribute this to ignorance or foolishness, but I disagree. It is the natural life cycle of personal finance. Younger folks have significant expenses, low incomes, and an expectation that later in life they will have higher incomes. The rational thing to do under those circumstances is what most of them actually do, go into debt while young and pay it off in middle age.

Imagine a sixteen year old who earned $5000 last year. Two years from now he expects to go to college and start acquiring student loans to pay for it. Does setting aside $5000 for retirement rather than borrowing $5000 less for college make any sense? Well it could, if he expected that the interest rates on the student loans would be lower than the return he will make in the IRA. But that is not very likely.

More likely, the teenager will want to apply his savings to college.  (Actually he’ll want to apply it to a car. His parents will want to apply it to college.) And for that purpose there exist 529 plans. Like a Roth, a 529 allows after-tax contributions to grow tax free. Unlike a Roth, you can withdraw the money to pay for college. And the contribution limits are much higher. Of course, the teenager will miss out on the fifty years of compounding trick, but let’s face it, even if he was grateful, it is doubtful you will be around to be thanked.

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