Did you know that anyone with earned income is potentially eligible to fund an Individual Retirement Arrangement (IRA)? There are income limits that prevent high income earners from funding Traditional or Roth IRAs, but for a large portion of the population, funding an IRA is a viable option.
Here is an interesting opportunity. Let’s say you have a teenager who works part time or has a summer job. As long as they have “earned income” (i.e. income reported on a W-2 or 1099) they are eligible to open an IRA.
How much can be contributed?
An individual can contribute a maximum of $5,500 per year or up to the amount of earned income (whichever is less). This contribution limit of $5,500 (or earned income) applies to either type of IRA (Traditional, Roth, or a combination of both).
When is the deadline for a contribution?
Contributions can be made for the prior tax year, up until the IRS tax filing deadline (usually April 15th of the following year – but this deadline is April 17, 2018 for the 2017 tax year).
That’s great, you say, but my teenager can’t afford to contribute all of their earnings from last year. They either spent some, most, or all of it or may be saving it for some other purpose. There is no rule that says it has to be funded out of their own pocket – a parent, grandparent or anyone else can do so on their behalf.
Consider a Matching Program
Here is a way to incentivize your hard working teenager. You could offer to match a set percentage (or specific amount) of anything your young earner contributes, much like an employer 401(k) plan with matching contributions. You could consider matching dollar for dollar, 50 cents for every dollar, or anything else you desire. You may even consider letting them keep their earned income and match their full income (subject to the $5,500 maximum allowed) and contribute it to the IRA for them. This could be a strong incentive for them to work and earn income when they have an option to do so.
What we do: Before we started saving in a 529 plan for our daughter’s college education, we contributed savings into a UTMA custodial brokerage account for that purpose. (Had we known about the advantages of the 529 plan when she was born, we would have started funding that instead.) Since her in-state college costs will be fully covered with assets in the 529 plan, each year as she has earned income, we transfer funds from the custodial account to her Roth IRA to fully fund her yearly contribution.
I have discussed the power of compounding previously in my post Harness the Power of Compounding. As you may recollect, the earlier one starts saving and investing, the greater the opportunity for the effects of compounding to shine. An IRA account could be a big jump start for a young person with a 50-year retirement time horizon!
What type of IRA should be utilized – Traditional or Roth?
The primary distinction between the two is that the Traditional IRA allows the account owner to deduct the amount of the annual contribution on their tax return while the Roth IRA does not offer any tax deduction for contributions. However, distributions from Traditional IRAs are subject to taxation at the time of withdrawal (plus a 10% penalty if taken before age 59 ½), whereas Roth IRA distributions are not subject to taxation upon withdrawal (some restrictions apply). Roth IRAs also have the added benefit of allowing owners to withdraw their contributions at any time without penalty (or tax). Any earnings within a Roth IRA may be subject to a 10% penalty if withdrawn prior to age 59 ½ (there are some exceptions).
The general rule of thumb when deciding which type of IRA to choose is this – if you expect to be in a lower tax bracket today than in retirement, a Roth IRA would most likely be preferred; alternatively, if you expect that your tax bracket is currently higher than it may be during retirement, you may benefit more from a Traditional IRA.
Since a teenager (or newly employed individual) is likely to be in a low tax bracket, or potentially not even subject to any taxes due to the Standard Deduction, a Roth IRA is usually the better option.
Something to be aware of: if the intended owner (i.e. the teenager) is not yet 18, the IRA account will need to be a custodial IRA for the benefit of the child. Once the child reaches the age of majority (18 or 21, depending on the state of residency), the IRA account can be transferred to the sole ownership of the beneficiary. Frequently a parent is the custodian until the age of majority.
Do I have enough money to even consider opening an IRA?
Many discount brokerage firms have no minimum deposit requirements when opening a new account. (It is a competitive industry, afterall.) However, keep a sharp eye out for all possible fees associated with any account. Shop around to find your best option.
Once an account is opened and funded, investment options such as mutual funds may have their own minimums you need to consider. For example, many Vanguard funds have a $3,000 minimum investment requirement, however, there is a way to avoid the minimum. You can opt to buy Exchange Traded Funds (ETFs) which are often just classes of shares of the same fund. Often they have even lower expense ratios than the mutual fund versions.
ETFs are bought and sold in the open market just like shares of stock and are usually subject to a commission. However, many brokerage firms have lists of no-fee ETFs, or allow you to purchase their own ETFs at no charge. So, the only real limitation to how much money you need to invest is the price of one share of the ETF you intend to purchase.
As tax day is rapidly approaching, consider funding last year’s allowable IRA contribution amount before the 2017 funding window closes! Maybe one day your (soon to be adult) teen will thank you.