Summer jobs present opportunity for Roth IRAs

Does your child (or grandchild) plan to be working this summer? For some young family members, a summer job is nothing more than a means to an end: to provide some additional cash flow to offset what their parents are less willing to supply for “something extra.” However, for others, a summer job may provide them with more money than they need and they’ll end up flush with cash.

For either category, a summer job can offer a wonderful opportunity to help the next generation learn about the investing process and begin thinking about how and where to save their money. In particular, contributing these savings to a Roth IRA or Custodial Roth IRA (for minors) offers a unique opportunity to take advantage of the child’s low marginal tax rate and a long time horizon for compounding growth.
The Basics

To start, let’s review some of the basics of a Roth IRA and how it differs from a traditional IRA.  While both traditional IRAs and Roth IRAs offer tax-free growth while the funds remain within these retirement vehicles, the Roth IRA is funded with after-tax dollars and a traditional IRA is generally funded with pre-tax dollars. Additionally, for a Roth IRA, the IRS has stated income limits that can prevent someone from making direct Roth contributions in a given year due to their income level. For a traditional IRA, there isn’t an income limit for contributing to the account, however, there are limits for being able to deduct the contribution from your income for income tax purposes. When considering a person’s earning potential, using those years when their income is lower offers a great opportunity to start funding a Roth IRA as they are likely within the income limits and might not be subject to much or any income tax on their earnings.

One advantage a Roth IRA has over a traditional IRA is with respect to distributions prior to age 59 ½. A Roth IRA account owner can take a penalty-free withdrawal at any time up to the amount that has been previously contributed. Compare that with traditional IRAs that typically impose a penalty on any “non-qualified” distributions prior to age 59 ½. Roth IRAs also allow penalty-free distributions from earnings, up to specified limits (like traditional IRAs do), for certain expenses such as a first time home purchase, qualified education expenses, birth/adoption fees and in the case of disability.

In addition, Roth IRAs do not require the account holder to take Required Minimum Distributions (RMDs) once they reach a certain age. Although this may not be something a younger person is concerned about today, it is a great point for discussion when choosing a savings vehicle for their hard earned dollars. With a traditional IRA, the years of tax-deferred growth comes to an end once the account owner reaches their RMD age (currently age 73 for those born after 1950, but moving to age 75 for those born after 1959). These distributions are taxed as ordinary income, which can create a sizable tax bill every year for those who have significant tax-deferred accounts. For a Roth IRA, because RMDs do not apply, the account value can continue to grow tax-free without forced taxable distributions.
Next generation planning

While the next generation may have little to no interest in thinking about their future selves in 40-50 years, with that kind of time horizon, even some incremental contributions to a Roth IRA each year can add up to a nice tax-exempt nest egg for them in retirement.

For example, here’s a simple calculation of what a single contribution could grow to if fully invested over the time horizon:

Of course, the potential impact likely would be significantly greater if the account owner consistently contributed $7,000 each year while eligible.

While it may not be easy to convince a child to forego spending their hard earned dollars, this is where having planning conversations with your child (or grandchild) about the importance of saving and growing their own wealth may be helpful. Once the account is funded, it makes for an easy introduction into a variety of investing topics, such as helping them understand the difference between stocks and bonds, market cycles, risk tolerance, time horizon, compounding growth, passive versus active investing, taxable versus tax-deferred and tax-exempt accounts, etc.

Should you have an interest in learning more about the process of establishing a Roth IRA for your loved one, or how to approach the conversation with the next generation, please contact your CIBC Private Wealth advisor.

Keri Pankow is a senior wealth strategist at CIBC Private Wealth in San Francisco and Newport Beach, with over 5 years of industry experience.