The Guide to Roth IRAs for Teenagers

In a world where many adults are rarely thinking about saving for retirement, does it make any sense for a teenager to think about something like an IRA? It absolutely can make sense. If they’re eligible, starting a Roth IRA early could be life changing for your teenager. What’s the impact, can they do it, and how? Keep reading to find out.

 “She goes to inspect a field and buys it; with her earnings she plants a vineyard.” Proverbs 31:16

1. What is a Roth IRA?

A Roth Individual Retirement Account (IRA) is a type of retirement plan you can set up to save for retirement. The Roth IRA, as compared to a Traditional IRA, is distinct primarily due to the way it is treated for tax purposes. With a Roth IRA, you put money in that you have already paid taxes on. While in the IRA, money grows with no taxes due on interest or gains. Later in retirement (as long as you meet a few criteria) you can withdraw money tax free.

What is the advantage of opening a Roth IRA early in life?

A Roth Individual Retirement Arrangement can be an incredible teaching force for your teenager. The idea of putting money away is a great habit to establish early in life. Beyond that, the financial benefits are astounding. Compounding is one of the most powerful forces in finance. The more time you put toward compounding, the more powerful it becomes. If you take two people who invest equal amounts at ages 15 and 25, all things being equal, who do you expect to have more money at age 65? A few additional years makes an incredible difference.

2. Can a teenager have a Roth IRA?

Yes, they can in some cases. Keep reading for more on who can and cannot. In fact, a baby could possibly open a retirement account as well. The model you saw in a diaper commercial could possibly have a retirement account.

What are the requirement for a teenager to open a Roth IRA

Your teen, or child for that matter, may be able to open a Roth IRA, but has to meet the same requirement adults do to be eligible. Because of these requirements, fewer minors are eligible to start a Roth IRA than adults. The big key is having what the IRS calls “earned income.” Another way to think about this is money earned in a year from working. For example, a part time job at Chick-fil-A would meet the IRS definition of earned income. Interest income from a mutual fund in the teenager’s name would not. IRS Publication 590-A has a more complete listing of income that does and does not qualify for purposes of Roth IRA eligibility. Thinking about a Roth IRAs for teens in your life does have different considerations from the government, so bear that in mind. 

Pay close attention to the IRS definition of eligible income

For a teenager, this is the criterion most likely to prevent them from being eligible to start a Roth IRA. Although not all inclusive of possible scenarios, if your teenager receives a tax form (like a W-2) for the work they are doing then the odds are pretty good they will be eligible. If you’re unsure, it’s important to check with a qualified CPA or financial professional to make sure your family is on the right side of the IRS rules.

3. Steps to open a Roth IRA for a teenager

How does a teenager open a Roth IRA?

Select a custodian or provider

To establish an IRA, you need a place to hold the IRA. This is referred to as the IRA’s custodian. The custodian will hold the money, any investments for the IRA, and do administrative work like produce the tax forms you need for the IRS. Financial services companies like banks, brokerage firms, independent financial advisors, and more can set up IRAs. Not all of them, however, will establish a retirement account for a minor. You’ll want to check on this specific question when choosing a provider. Ask specifically if they can open a Roth IRA for a minor. Don’t assume that a firm does not offer the option if it’s not on their website. You may have to call and request an application for this circumstance sometimes due to the rarity of this circumstance. An investment account, UGMA, or a custodial account for a minor is something different.

What do you want in a provider?

There’s a lot of IRA providers out there and they offer different things. If it’s a deal breaker for your provider to have an Apple Watch app, then not everyone will make the cut.

Watch out for minimums

Minimums generally apply for an account or individual investments. Some companies will waive minimums when an account is for a minor. One circumstance to keep in mind is the minimum to start the IRA may be waived, but there may be a minimum for a particular investment option, like a mutual fund, you might want. It’s best to research ahead of time so you know what to expect.

Breadth of Services

What services do you need from a provider for your teen’s Roth IRA? Not all IRA custodians provide the same services. For example, if you want to be able to use investments like Exchange Traded Funds (ETFs), you’ll need to make sure the company has a brokerage account that offers this that option. If you prefer for the account to be managed (investments chosen for you), then you’ll need to choose a company that is willing to perform that service for this type of account.

Fees for a Teen Roth IRA

Fees are always important when it comes to investing. The more you pay in fees, the less you get to keep. Because your teen is likely starting with a modestly sized account, this can be even more important. For example, if an investment company charges a $50 a year fee on a $500 account that’s 10% of the entire account! While a $50 fee isn’t something anyone wants on their statement, it hurts much less for an adult who has a $5,000 IRA. Check fees carefully for anything that is ongoing like a maintenance fee or fees tied to activities like transactions you might pay.

Setup the Roth IRA for your minor

Once you choose a provider, you’ll be ready to set up the account. Because this is a less common scenario, your provider of choice may ask you to complete a paper application. The application will ask for the minor’s information like social security number, date of birth, and so forth. Separately, you will be asked to provide your information as a parent or guardian. Why? Because minors can not sign legal contracts, you’re doing the account application on their behalf. You’ll also continue to act on their behalf until your child reaches the age of majority. This is usually 18, but varies by state of residence. The application may also ask you how much money will go into the IRA initially. Some firms will give you the option of using a check or electronic bank transfer (ACH) to fund the account.

Funding the Minor Roth IRA

 Although the criteria to qualify a teenager to open a Roth IRA is specific, the details on where the Roth IRA money comes from is not. For example, once the teenager has qualified a parent or grandparent could put money in the Roth IRA for the teenager. The eligibility and maximum amount is still dependent on the teenager and the rules, but the teenager themself does not have to provide the funds. Some families will choose to gift the IRA contribution as a way to encourage the young saver. The teenager can also provide the funds directly from their own earnings or savings. 

4. How much money can a teenager put in a Roth IRA?

The amount your son or daughter can put in a Roth IRA is limited by IRS rules, just like for any adult. This includes eligibility to put money in at all or the maximum one can contribute. When eligible, there is a maximum amount that anyone put in a Roth IRA in a given year. This likely won’t come into play for your teenager. You’ll want to look at the amount of “earned income” during the entire year in question. If you’re unsure, check with a qualified CPA or IRS publication 590-A to make sure. Your teenager can contribute as much (within IRS maximum limits) as their earned income during that year. For example, if your teenager earned $500 during a summer job, then you could contribute up to $500 to the Roth IRA for that year.

How can a teenage minor’s Roth IRA be invested?

A Roth IRA for a teenager has the same investment options available for an adult’s Roth IRA. Some investment choices require more research and ongoing monitoring than others. Keep in mind that any investment selections, at the beginning or until the teenager is no longer a minor, are the responsibility of the adult you’ve put on the account. This can still be a tool you use to teach your son or daughter over time as they learn about investing. When you review the account online or check a statement, include your young retirement saver in the exercise to teach them this valuable skill. 

Mutual Funds

Mutual funds offer a way to pool your money with other investors and be invested across many different investments. A fund manager buys investments for the fund which sometimes number in the thousands of different securities. Some mutual funds buy investments of the fund manager's choosing and some mutual funds buy from an index (like the S&P 500) to mirror a part of the markets. 

Exchange Traded Funds (ETFs)

Exchange Traded Funds or ETFs are similar to mutual funds by offering a way to buy one investment and own many underlying investments. The key difference with ETFs is how you buy and sell them. Mutual funds are often bought directly with a mutual fund company. ETFs are bought in the open market similar to how stocks trade throughout the day. 

Individual Stocks

Individual stocks are what most people think of when they envision investing. This is the opportunity to buy shares in companies you're very familiar with and some you may never have heard about. 

Individual Bonds

Companies and governments borrow money for various reasons. When you buy an individual bond, the issuing business or government pays you over a set period of time. 

Bank Products

You can use bank products like Certificates of Deposit (CDs) in your minor Roth IRA. 

Other Stuff

There's other securities and investments that could go into your teenager's Roth IRA. Just because it is available, does not mean it's appropriate. Exotic investments abound, but are often inappropriate investments for this type of account. The likelihood is it is not. By the way, this is often the case for adult IRAs as well. 

The two solutions applicable for most folks

Although there's a variety of ways to mix and match the options above, most families will be best served by one of two options for investing their Roth IRAs. Both minimize the amount of time required to make these decisions. First, consider a type of mutual fund know as a "life cycle" or "target date fund". The idea here is a mutual fund with a future year (decades ahead) that automatically invests over time appropriately for someone's retirement in that future year. Good quality versions of these funds provide diversification and ongoing monitoring for a reasonable fee. Second, consider a fee-only financial advisor who acts as a fiduciary. Note: Someone who is a fiduciary means they are putting your financial interests ahead of your own. This is distinct and different from someone who just calls themselves a financial advisor or financial consultant. 

 Learn more about how Intrepid Eagle Finance serves a fiduciary for clients and helps with questions like minor Roth IRAs

5. Additional Questions and Considerations

Does a minor Roth IRA affect a parent’s taxes

You won’t pay more taxes or less taxes by virtue of a minor opening a Roth IRA. The IRS does want to know anytime money goes into or out of an IRA, also known as a contribution or a distribution. This will be reported on your tax return in any year money is going into an IRA. A qualified CPA or good tax preparation software can assist you with how to account for this on your taxes. Some adults make too much money to contribute to a Roth IRA causing them to worry their teenager will also be ineligible. Thankfully, the IRS looks at parents as a unit and children separately for purposes of these rules. In other words, it is possible that Mom and Dad could not be eligible, but your son could be.

What happens when my teenage Roth IRA owner becomes an adult?

When your teenager is no longer a legal minor (determined by your state of residence, but usually 18), you will remove yourself and place the Roth IRA fully in your son or daughter’s name. The IRA provider will likely ask for proof of age and also ask for some paperwork to complete the changeover. After that is complete, your young retirement saver is in control of the Roth IRA just like any other adult.

What about another kind of retirement account for my teenager?

A Roth IRA is not always the best choice. There’s retirement vehicles and even types of IRAs that could be more appropriate for a given situation. With that in mind, for a teenager who is eligible, able, and willing to put money in a retirement account, a Roth IRA will often be the best choice. This is primarily due to the unique tax nature of a Roth IRA. If you’re not certain, this can be an excellent question to ask a fiduciary financial advisor who has expertise on these types of questions.

Does a Roth IRA in a minor’s name affect college financial aid?

When you go through the financial aid process for college and fill out the FAFSA form, assets in retirement accounts are not counted as assets for purposes of financial aid. If you were to remove money from the Roth IRA (called a distribution) then the amount you remove would be counted for purposes of financial aid. Since IRA money is earmarked for retirement anyway, this should be avoided if possible.

Can money be removed from a Roth IRA for college?

The short answer is yes. There are caveats though. First, by removing money from a retirement account the original goal of the money (compounding over decades) won't have a chance to happen. Next, there are some complications on the tax and financial aid front. Having money in a Roth IRA is not counted against you for purposed of financial aid. Money taken out of a Roth IRA, however, will be counted against you for purposed of financial aid eligibility. From the tax lens, it's more complicated. You won't pay a tax or penalty on any contributions you previously put in. For any earnings above that amount, you'll owe income taxes. In addition to that, there's a 10% early withdrawal penalty. Your minor may be able to qualify for an exception to that penalty for what the IRS calls "qualifying education expenses." There's specific things that qualify, you need documentation, and the burden of proof will be on you to apply and validate your eligibility in the eyes of Uncle Sam. It's highly recommended you consult with a qualified professional before going down this path. 

Congratulations

If you're even asking this question, good for you. This means you're a good parent and thinking about how to set your son or daughter up for financial stability throughout their whole life. Keep teaching them right!

We help Christian families on their journey to financial freedom. If you would like more posts from us on how to balance what's truly important with your finances, please sign up for our free newsletter. If you’d like to hear more about how Intrepid Eagle Finance helps families manage their financial lives, click here to learn more and schedule a free consultation.