TEENS AND THEIR MONEY

Taxes, IRAs, Drips, and Savings Accounts

Teens and Their Money

By Selena Maranjian

The last article introduced you to several kinds of investment accounts. There are a few more options you should know about, though, and some things to keep in mind, such as taxes.

Taxes

If you've been working a part-time or summer job and have been drawing a paycheck, you'll notice that our friend Uncle Sam likes to take a bite out of every paycheck for taxes. He's got his eye on your brokerage account, too.

Let's say that you're invested in a bunch of shares of Ford Motor Company stock. Each quarter, you're paid a cash dividend by Ford. You'll have to report this amount on your tax return because it counts as taxable income to you. If you received a total of $40 during the year in dividends, you may owe around $6 in taxes on it.

Taxes will also affect your brokerage account when you sell stock. If you sell shares for less than you paid for them, you have a "capital loss." On your tax return, you'll get to deduct that amount (up to $3,000) from your income. So if you earned $2,000 during the year and had $500 in losses, it's as if you only earned $1,500 during the year -- so your taxes will be lower.

If you sell any stock for more than you paid for it, you've got a "capital gain" on your hands, and that's taxable. If you held the stock for a year or less, the stock is taxed at your tax rate for general income. If you held it for longer than a year, it's a "long-term gain" and is taxed at a rate that for most people is lower than their income tax rate. Most teens don't earn too much in any given year, so they're usually taxed at a low rate.

If you have gains and losses, you can offset your gains with your losses. So if your gains totaled $800 and your losses were $300, it will be like you only gained $500 -- that's the amount that will be taxable.

Mutual funds work in a similar manner. If you sell your shares of a fund, you'll have a gain or loss -- which is taxable. Funds holding stock that issue dividends will report to you your share of the dividends -- and that amount is taxable.

If all this talk of taxes is getting you down, there's an alternative -- an IRA.

IRAs: Traditional and Roth

When you're opening a brokerage account, one kind of account you can open is an "IRA." An IRA is a retirement account, designed to contain investments people make for their golden years. The money you put in isn't supposed to be removed until you're in or near retirement. IRAs are different from regular brokerage accounts because they are "tax advantaged." Using them can help you pay less in taxes.

Teens can open an IRA account through many banks, brokerages, mutual fund companies and other financial firms (again, a custodial account, with a parent or guardian). You can only put money into an IRA account if you have earned income. That $500 you got for your bar mitzvah or from Uncle Fester won't work. There are limits to how much you can put into an IRA, too -- for 2002, the limit is $3,000 (of earned income, remember). There are two main kinds of IRAs: traditional and Roth.

  • A traditional IRA is one in which you park "pre-tax" money. The money you invest gets to grow in a "tax-deferred" manner. This means that you can buy and sell stocks or funds in your account and can generate capital gains, but you're not taxed on them -- yet. You don't get hit by taxes until you start taking your money out at retirement. (If you try to take money out before you hit retirement age, you get socked with fines.) So if in one year you earn $3,000, on which you'd normally be taxed, you could park, say, $1,000 of it in a traditional IRA. Doing so means you get to remove that $1,000 from your income. So your taxable income becomes just $2,000 -- and you therefore pay less in taxes now. Plus your $1,000 is growing in a tax-deferred account. Nice! When you withdraw your money, perhaps at age 66, you'll be taxed on it then.
  • With the Roth IRA, you invest "post-tax" money in it, and you're supposed to leave that money invested in that account until you hit retirement age. At that time, you can start withdrawing your money -- not tax deferred, but tax free! Here's how it works. If you earned $3,000 in a year and invested $1,000 of that in a Roth IRA, you'd still have $3,000 in income to report for the year. You don't get an upfront tax break, as you would with the traditional IRA. Instead, you get the tax break when you withdraw the funds -- and a big break it is. You withdraw the money tax free.

If you managed to invest $1,000 per year in an IRA from age 20 to age 60, and it grew at 11% per year, you'd end up with about (ready? take a deep breath!) $582,000 in your IRA. Yowza. If that were in a traditional IRA and your tax rate at the time was 25%, you'd end up paying around $145,000 in taxes and keeping around $436,000. Not bad. But if that money were in a Roth IRA, you'd get to keep the entire $582,000. For most teens, the Roth IRA is probably the best IRA option.

It's probably hard to imagine yourself at age 25, much less age 60, so this might not seem that exciting. But note that you don't have to sock every spare penny you get into an IRA for your retirement. That half-million can be earned with just a measly $1,000 per year. (Of course, investing a little more each year, if you can, will yield even more impressive results.) You can invest other amounts in a regular taxable brokerage account, and use that money much sooner than retirement, if you need or want to. But it's definitely worth looking into opening an IRA account, even in your teen years. You might be the first teenager on your block with both a Roth IRA account and a regular brokerage account!

There's more to learn about IRAs. You can read up on them all over the web, including at our Taxes area and our Retirement area. Note that some banks and brokerages aren't eager to set up custodial IRAs for minors -- you might have to look around. Don't let anyone tell you that a minor isn't allowed to start an IRA, though -- anyone of any age can, as long as it's with earned income.

Index Funds Are Enough

Just a quick reminder: Although these articles are telling you all about lots of different kinds of accounts, remember that you can get by and do well with just an index fund, which you can invest in directly through a mutual fund company. (You can also invest in index funds through Roth IRAs and other savings accounts.)

Newfangled Brokerage-like Things

In recent years, there have emerged some companies that operate very much like traditional brokerages, but with a few twists. Two examples are ShareBuilder (866-747-2537) and BuyandHold.com (800-646-8212). These outfits have tried to offer people the ability to buy and sell stocks for even less in commissions than typical discount brokerages. They've charged as little as $2 or $4 per trade, although recently some of them have increased their fees or have added monthly charges.

What's the catch? Well, some of them will execute your orders as infrequently as just once a week, to keep their costs down. (Since a good Foolish investor isn't trying to rush in and out of stocks very often, this isn't usually a big problem.)

If you're interested in these companies, call them or check out their websites, and make sure you get all the information you need before you sign up. Ask any questions you didn't find answers to, such as whether they'll let you set up a custodial account with a parent and how much they'll charge you monthly and/or per stock purchase or sale.

Drip, Drip, Drip

Can you believe there are so many different kinds of investment accounts? We're not even done yet! One very effective way for teenagers with limited funds to invest is through "Drips." That's a nickname for dividend reinvestment plans (DRPs) or direct investment plans. If a company offers a Drip plan (and more than 1,000 major companies do), it means you can buy shares of its stock directly from the company, bypassing brokerages and their commissions. (Woo hoo!) This used to be a major advantage, since brokerage commissions could be $50 or $100 or more per trade. But now with some discount brokerages charging $8 or less per trade, the difference has shrunk.

One huge benefit of Drips is that they permit you to have any dividends the company pays you reinvested in additional shares of stock. So if you get $15 in dividends from a stock that's currently trading around $30 per share, the Drip plan will buy you half a share of stock for your account with that $15. (You usually can't buy fractions of shares, but through Drip plans you can.) Some Drips require you to already own one share of the company's stock before you can open a Drip account -- that can be a bit of a hassle. Others permit you to buy your very first share through the Drip.

You can learn more about Drips and which companies offer them in our book, The Motley Fool's Investing Without a Silver Spoon: How Anyone Can Build Wealth Through Direct Investing by Jeff Fischer (who began investing as a teen). (The book is a few years old and should be revised within a year or so.) Here's a Fool article on Drips. You can also get the latest scoop and more info at NetStock, Direct Investing, and Drip Central. The National Association of Investors Corp. also offers a low-cost investing program.

Savings Accounts for Education and College

Two other kinds of accounts are designed to help you (or your parents) save for your educational expenses -- which usually means college.

Qualified Tuition Plans / 529 Plans

Qualified Tuition Plans (QTPs) are also known as Section 529 plans, or just 529 plans. These investment accounts are offered by most states (and some institutions such as schools). They let you park money in the account and usually offer you just a few choices of what you can invest that money in. Like IRAs, you can't take out money whenever you want -- unless you pay a penalty fee. The money is supposed to be withdrawn just for educational expenses. The great thing about these accounts is that you (and your parents, or anyone) can sock away a lot of money in them (more than with the Coverdell ESAs explained below, for example), and when you take out the money according to the rules, it's all tax-free. There are no capital gains taxes to pay, even if your money has tripled in value while it was invested. Learn much more about these plans at http://www.savingforcollege.com/.

Coverdell ESAs

A Coverdell ESA account can have up to $2,000 invested in it per year. It's very much like a Section 529 plan, except that you have a lot more choice about how you invest the money in the account. You can invest it in whatever stocks or bonds or mutual funds you'd like. You can open a Coverdell ESA account through most brokerages and other financial institutions. When you withdraw money for qualified education expenses, it's tax-free.

Remember that having considerable savings socked away for college can possibly decrease the amount of financial aid you may qualify for. But it may well be worth it, as the money in your account is money you know you have, while you never know exactly how much financial aid your preferred school(s) will offer you.

Learn more about 529 plans and Coverdell ESAs in our College Savings area.

UTMAs and UGMAs

Finally, know that there are two more kinds of special accounts -- UTMAs and UGMAs. (Pretty names, aren't they? They're short for Uniform Gifts to Minors Act and Uniform Transfers to Minors Act.) These are essentially "trusts," accounts set up by your parent(s) or guardians where they're the "trustee," investing money for you, the minor. Once you turn 18 or perhaps 21 (or sometimes even 25), the account becomes your property, and you're free to do with it what you want. Actually, it's been your property all along -- you just haven't been legally allowed to control it until a certain age.

There are some benefits and disadvantages to these funds. You and your parents can learn more about them at Fairmark.com.

Learn More

This article is adapted from our book, The Motley Fool Investment Guide for Teens: 8 Steps to Having More Money Than Your Parents Ever Dreamed Of. To learn more about investing, managing your money, and how to open accounts, check it out.

If you have some questions about anything you've read here, you can ask them on our Teens and Their Money discussion board. Or just drop in to see what other teens are saying.

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