[As with anything tax-related, see my disclaimers.]
I first heard the phrase “Roth IRA” as a graduate student. Jim, a fellow graduate student, and I were talking about saving and investing and he told me about his Roth IRA account. I was 25 years-old at the time, and I remember feeling that I had missed out on some vital financial lesson. Shortly after graduate school, I opened a Roth IRA and started contributing to it annually.
The Power of Compounding
The following chart compares contributing to a Roth IRA at different ages: 15 years-old and 25 years-old. Assumptions:
- The 15 year-old maximizes their contribution for the first ten years and then never contributes again, making nearly $60k total contributions.
- The 25 year-old doesn’t start contributing until they’re 25 but then contributes the maximum allowed every year to their 60th birthday, including making “catch-up” contributions after age 50, contributing nearly $300k over that time.
- Maximum allowed contribution amounts increase by $500 every six years
- 8% annual return, close to the historical S&P 500 return between 1957 and 2018.
Contributing as early as possible trumps contributing five times more! The power of compounding!
Matching your child’s Roth IRA Contributions
How do you encourage a child to make contributions to their Roth IRA? The same way corporations do it: matching contributions. A couple of years ago when my oldest got her first job as a lifeguard for the local pool, I told her that I would match, dollar-for-dollar, any contributions she made to her Roth IRA. We opened a custodial Roth IRA account at Vanguard and put her first contribution and my match into an index fund. Now, three years later, I’m getting ready to make matching contributions to both her and her sister’s accounts.
Why a match? Perhaps you’re one of those wealthy sorts who could deposit the complete amount they are eligible to contribute. That’s a gift and no incentive was created. Feel free to match as much as you want, but
Why a Roth IRA?
When a child first starts earning, they are typically in the zero tax bracket, the ideal time to contribute to a Roth IRA for tax-free growth.
Is it legal?
Typically you can only contribute to your own Roth IRA and not to someone else’s. However, money is fungible. This means that my “contribution” is really just a cash gift to my child in exchange for them making 100% of the contribution. This means that the child must still earn a minimum of their contribution and whatever “match” you provided. If they only made $500 and you match dollar for dollar, they can only contribute a total of $500 so your match could be at max $250. The child is still limited by how much earned income they had for the year, putting an upper limit on how much you can match.
The IRS has restrictions on what kind of income a child can “earn.” Getting paid for babysitting the neighbor’s children counts while getting paid for babysitting a sibling doesn’t. Income from a family-run business can count as long as you follow the documentation guidelines. Your child will need to file a tax return, but at their age it’s likely to be a super simple return.
Let me know what you think about matching your child’s Roth IRA contributions.