Originally published in the Retirement Daily
The 16th birthday is a huge rite of passage for a lot of teenagers in the country. This is when they start officially driving on their own, without Mom or Dad, or the brave individual that was responsible for teaching them how to drive.
It’s common for teens to experience other firsts besides hitting the road, including their first job. While the idea of a newly disposable income is tempting, starting smart saving habits such as opening a Roth IRA account is paramount.
The Roth IRA Account Features
The Roth IRA account was created over 20 years to help middle Americans save for retirement without impacting government revenue. Over the years, updates have continued to make the account more and more attractive to investors. A quick summary of the key features that define it are:
- The contributions are after-tax and there is no age limit.
- Contributions can only be made with earned income.
- In 2021 the maximum contribution is $6,000, or $7,000 if over age 50.
- There is an income limit, but the backdoor option has eliminated the income limit.
- The account grows tax-free, and there are no RMDs (required minimum distributions).
- The initial contribution can be taken out anytime, penalty and tax-free.
- Earnings can be withdrawn at age 59 ½ or older, penalty and tax-free, if the account has been open for 5 years.
In the next section, I’ll address why the Roth IRA account is such a great idea for teenagers.
The Roth IRA Account Grows Tax-Free
Most teenagers are in shock when they get their first paycheck and realize how much has been withheld for taxes.
Let’s use Mia as an example. Over the summer, she is working 20 hours a week at the local grocery store. Her excellent pay is $15 an hour. Her weekly pay is $300, which goes down to $271.18 after federal taxes. State taxes might lower that some more. She is not going to be very happy about having the government take some of this money.
Teenagers tend to have very strong opinions, and they will not hold back, especially if they think something is unfair. With a couple of teenagers in the house, I am experiencing this firsthand.
One way to address this issue is to explain to them how the tax system works, and then show them how they can take advantage of the current rules: They have earned income, most likely they will be under the tax threshold, and their money can start growing tax-free.
Nothing like motivating a teenager to beat the system. The best vehicle for this is a Roth IRA account.
Driving Freedom and Increased Spending
Being able to drive gives teens a lot of freedom in terms of where they can go and who they get to hang out with. With the added freedom, their spending is likely to go up. This is easily met with the increasing income they have been earning. You can and should talk to them about putting some of it in a savings account.
However, they are likely to scoff at the high yield savings accounts currently earning 0.5%. The solution is a Roth IRA account that can grow at the market rate depending on what you invest in and never have to pay taxes on the money.
A Roth IRA Account and Compound Interest
A Roth IRA account is one of the best tools for teaching teenagers the power of compound interest. To be at its most efficient, the money should be left in the account for a long time. Since the Roth IRA is a retirement account, it is designed to have the money staying in the account for years.
Hence, it’s one of the most practical tools for teaching them how this works and more crucial how it can work to their advantage. Use this handy calculator to illustrate the concept.
It’s also a great opportunity to explain the rule of 72, which is a simple way of determining how long it will take for an investment to double at a given fixed annual rate of interest.
Learn by “Having Skin in the Game”
Teenagers are open to learning, but their busy social lives, aided by the newly acquired driving privileges, do not always work in their favor. To make it more appealing, they need “skin in the game.” The best way to do this is with their newly earned money.
Have them learn to invest and research what they want to invest in with the Roth account. The beauty of the account is that they (with your guidance), can invest in just about anything with a few limitations.
Help Them by Investing in Their Future
I have met a lot of parents who are keen to teach their teenagers how to save and invest. They are willing to do a lot of things including giving them the money to invest. It is a great idea, but in my experience not having anything attached to the money makes it less effective.
Since they are now working, and are having to make some money decisions, offer to match their investments to whatever percentage you are comfortable with.
The account cannot go beyond their total earned income or beyond the annual contribution ($6,000), but because it is going to grow tax-free it’s more impactful.
The Roth IRA account is one of the best ways to prepare teenagers for the future.
The Contribution Can be Withdrawn Anytime
When talking to teenagers about the Roth account, I don’t lead with this, but it may be necessary to explain it to those who think they’ll need the money before retirement.
The contribution in the Roth account can be withdrawn anytime with no penalties, as it’s already been taxed.
For the busy teenager, this can act as an emergency fund, but only as a last resort. This will hopefully eliminate any objections they may have to invest the money.
At 16, most teenagers are thinking about college. The Roth account does not impact student aid. It is a retirement account and retirement assets are excluded when calculating the expected family contribution.
If you are part of America’s first generation in this country, this is a great way to start building generational wealth and deepen your roots in the country. It’s worth doing it for your teenagers.
I’ve taken up my own advice and opened a Roth IRA account for my teen. Here are the 6 Steps I took to Open the Teen Roth IRA Account.
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