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IRAs for, like, teens? Don’t roll your eyes

By Dave Carpenter
Associated Press / February 21, 2010

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CHICAGO - Saving for a teenager’s retirement might sound far-fetched to parent and child alike, especially with college costs looming. Who’s got time or money to be planning for the 2060s?

Yet setting up a Roth individual retirement account for your teen can be a smart and rewarding move to consider at tax time. You don’t have to be rich to do it, either.

It makes good sense to set aside money that can grow many times over by the time it’s put to use. And establishing an IRA with a teen’s own cash - perhaps supplemented by Mom and Dad or the grandparents - can convey a powerful financial message that no pep talk could match.

“It provides an opportunity to engage a generation that typically doesn’t focus much on investing with something that’s theirs,’’ says John Heywood, a principal in Vanguard’s retail investor group.

A Roth IRA differs from a traditional IRA in that you contribute with after-tax money but pay no taxes on withdrawals, meaning all growth is tax-free.

As with Roths for adults, not every teen qualifies and there are strict rules to follow.

You can only open one if the child has income from a job - allowances don’t count. You can’t contribute more than the child made in any given tax year, up to the limit of $5,000. And if you want to apply the teen’s earnings from bagging groceries or waitressing last summer, the deadline for making 2009 IRA contributions is April 15.

If you are self-employed, you can employ your children, pay them a salary, and open a Roth on their behalf. Just make sure they do real work for a reasonable wage and you file W-2 forms reporting their earnings to the Social Security Administration.

Leslie Beck of Cupertino, Calif., and her husband, Doug, started a Roth for their then-16-year-old daughter Diana in 2008 and insisted she contribute $3,000 of her $6,200 in income to the account while also setting aside money for college.

Leslie had the clout of being not only mom but boss, hiring Diana to do filing and administrative work for her investment management firm after school. She also promised to match Diana’s contributions dollar-for-dollar the second year, ultimately giving her $1,500 of “free money’’ last year.

Still, a retirement account wasn’t an easy sell. Her daughter viewed it as a black hole.

Now a freshman at the University of California-Santa Barbara, Diana still is hardly thinking about retirement. But she acknowledges her mom’s idea wasn’t a bad one.

“With times as tough as they are, you know - it isn’t too early to start saving,’’ she says.

Here are four reasons why a Roth IRA can be a good idea for your teen:

Benefits from decades of compounding. Long-term compounding, or generating earnings from previous earnings, won’t necessarily make your kid a millionaire. But it could with future contributions.

Consider a hypothetical case in which $2,000 is put in a Roth annually for four years - each year of high school, for example.

Assuming the money grows at an annual rate of 8 percent, the account would total about $456,000 in 50 years when the teen has reached retirement age. And if the account-holder faithfully contributes $2,000 at the start of every year for 50 years, it would be worth more than $1.2 million.

Jump-starts savings. Starting to save early for retirement is more important than ever at a time when the classic three-legged stool approach to retirement security - employer pension, Social Security, and personal savings - is teetering.

Employer pensions are vanishing so fast that no young person should expect to have one. The number of workers with a company-provided pension fell to 15 percent in 2008 from 40 percent in 1975, according to the Employee Benefit Research Institute.

Offers tax advantages. A teenager working part time will have one of the lowest tax rates, making it a good trade-off to pay taxes on contributions now rather than accumulated retirement savings in a few decades when the total and the tax rate will be much higher.

The tax-free withdrawals allowed with Roths mean having an account is a double winner for a young person in terms of taxes.

Doesn’t require large contributions. Contributing the yearly maximum of $5,000 to a teen’s Roth, or even $2,000, just isn’t feasible for most families. But small amounts are fine, too. Even a few hundred dollars can start snowballing into significant money by retirement time.