Parents want to make sure they give their children the best possible start in life. But many parents don't make one simple move that could turn their children into multimillionaires by the time the kids are ready to retire. That move: opening a Roth IRA when a son or daughter is very young and contributing a few hundred dollars to it every month.
Not every parent can afford to do this, of course -- and there are requirements for opening a Roth IRA that not everyone can meet. Still, the younger a child is when a Roth IRA is opened, the greater the chances he or she has of becoming wealthy. While you may not be able to max out the annual contributions or open the account when your child is a newborn, it's worth learning how to make use of a Roth IRA as soon as you can.
How a Roth IRA could turn your child into a multimillionaire
A Roth IRA is a retirement account that comes with significant tax advantages. Money invested through a Roth IRA is exempt from dividend taxes and capital-gains taxes, which means any profits made by selling investments within the account will not be taxed. Further, any "qualified" distributions are also free from taxation. In other words, as long as a withdrawal from the account meets certain requirements -- namely, if the account has been open for at least five years and the owner is at least 59-1/2 years old -- then that income will not be taxed.
If you open a Roth IRA for a child when they turn 12, invest $5,500 into that account each year (the current contribution limit as of 2017), and have your child continue doing the same each year after they turn 18, they would have more than $3 million by age 65 without ever increasing their contributions, assuming the account earned a respectable 7% per year.
The total amount of money invested over the course of the child's life would be just $291,500, but the magic of compound interest and tax-free growth would mean your child would never have to worry about running out of money during their golden years.
Let's say you can't quite spare $5,500 a year, or about $460 a month. If you (and later your child) could invest half that amount and earn the same returns, your child would still have a cool $1.5 million to their name by age 65. And that's not even accounting for their likely growing salary, which will enable them to contribute more as time goes on.
Your child needs to have income to invest in a Roth IRA
Although the benefits of opening Roth IRAs for your children are undeniable, there's a caveat that make this tricky: Children can only contribute to a Roth IRA if they have declarable income; the money cannot come from a gift. Further, the annual contribution cannot exceed the child's earned income for that year. However, there are often solutions to this problem. If you or any member of your family has a business, consider hiring your child. Otherwise, encourage your child to get a summer job such as mowing lawns or babysitting.
As your child gets older and is able to take on part-time jobs, have your child invest every dollar earned from his or her paycheck. As long as you can afford it, simply give your children allowances that are somewhat proportional to their pay, so they can invest their full wages in a Roth IRA. Your children will still have spending money, but their earned income will be working quietly behind the scenes to make them rich.
The Motley Fool has a disclosure policy.