A Roth IRA provides generous tax breaks for retirement savings -- especially if you invest in it early.
See, while a traditional 401(k) and IRA allow you to make pre-tax contributions, a Roth takes after-tax contributions but allows you to make tax-free withdrawals. If you invest in the account early, your money can grow for a very long time and you can take out all of your gains without owing taxes on them (as long as you follow a few basic rules).
The big question, however, is just how early can you invest in a Roth IRA? And the answer may surprise you. It's an answer that parents should know about, because they may be able to put their children on the path to riches with very little effort.
Starting a Roth IRA early can really pay off
To start a Roth IRA for yourself, you need to be 18 years old. But that doesn't mean a Roth IRA can't be opened for someone younger. Parents can open a Roth IRA on behalf of their children, acting as a custodian of the account until their kids reach adulthood and assume control. And there's no minimum age to open an account when you take this approach -- as long as their children qualify.
Unfortunately, that generally doesn't mean you can start putting money into a Roth IRA for your newborn. That's because you can invest in one only if your child has earned income (income from a job). Parents can't give their children money to put into a Roth because the income wouldn't be earned. The good news, though, is that as soon as your child starts earning any money, they can begin contributing.
Say your child gets a summer job mowing the neighbors' lawns or walking their pets at the age of 7. Your child can contribute the money earned from these jobs into an IRA. If your kids don't necessarily find this the most exciting use of funds but you feel it's important for them to invest, you could always have them invest the income they earned and then give them some spending money as a gift.
If your children make these early Roth IRA contributions, chances are good they'll be doing so at a time when they aren't making a whole lot of money. That means they'll probably have earnings below the threshold where they'd have to pay federal taxes on their earnings. Roth IRA contributions are typically made with after-tax dollars, but since your kids won't owe taxes anyway, this won't matter to them. And since these accounts allow tax-free growth and tax-free withdrawals, your children will enjoy many years of compounding without the IRS taking a cut.
To understand just how beneficial this can be for your children, consider what would happen if your kids invested just $1,000 annually in a Roth IRA from age 6 to age 18 and earned an 8% average annual return -- and then never invested another dollar. By the time they reached 18, they'd have around $18,977 -- but by the time they turned 65, this $18,977 would have turned into more than $700,000 due to years of tax-free growth. And any withdrawals they make from that $700,000 would be completely tax-free (provided they follow Roth IRA withdrawal rules).
Taking advantage of the opportunity to invest in a Roth IRA when you're young (or to invest on behalf of your children while they are young) can clearly make a huge impact and is definitely a financial move worth considering.