Advice & PlanningRetirement

Retirement for Teens?

Helping your children set up Roth IRAs now could pay off later — not only in sizable nest eggs, but also a solid grounding in financial basics. 

Retirement for Teens?

At age 16, it's hard to see past college (or even the weekend), much less into retirement. But parents and grandparents tend to take a longer view, and helping your teens set up and fund Roth IRAs could potentially provide benefits in that far-distant time when their working days are through. The tax-deferred compounding and flexibility that make a Roth IRA a powerful savings tool for adults can be even more compelling for someone 50 years from retirement, says Charles Toth, Director of Product Management and Personal Retirement for Bank of America Merrill Lynch. These specialized accounts also create unique teaching opportunities that can help your children get an early start on becoming savvy and sophisticated investors, Toth says.

Learning what 50 years can do

One financial basic a Roth IRA can teach is the power of compounding. As an abstract concept, the notion of building on returns year after year may not resonate with a 16-year-old. But show how savings might grow in a Roth IRA over half a century and even the most jaded teenager may sit up and take notice. For example, an investment of just $2,000 annually in a Roth IRA for the next four years can grow to more than $450,000 in 50 years, assuming an 8% annualized return. "That kind of eye-popping future benefit can go a long way in communicating to younger people the importance of developing good savings habits," says Toth.

This could also be a good time to introduce your teens to the realities of taxes (and tax deductions). Teenagers may initially be put off when you explain that, unlike contributions to a traditional IRA, money going into a Roth can't get deducted from a person's taxes. They're likely to brighten, however, when you point out that workers who earn less than $5,700 a year don't have to pay income taxes. A teen with a $10-an-hour job could funnel all of his or her savings from the next few summers (up to $5,000, the maximum total yearly contribution to any kind of IRA for those under age 50) into a Roth IRA and, decades from now, potentially withdraw a few hundred thousand dollars without ever having to pay federal income taxes on any of it. (See illustration below.)

Of course, investments can also lose value and a Roth IRA can be an effective vehicle for teaching teens other investment basics, such as the importance of diversification, sound fundamentals and the trade-offs between risk and return. Toth recommends sitting down with your kids to research and select the investments together. "When you're investing for so many years, you can really see how the extra risk of equity investments may pay off in better returns compared with certificates of deposit or money market funds," Toth says.

The family matching plan

Teenagers don't even have to wait until they reach age 59½ — the usual cutoff for penalty-free distributions from retirement accounts — to tap their Roths. Roth IRA contributions (though not the investment earnings) can be withdrawn at any time for any reason. So your children could use some of their contributions to help pay for college or live abroad. And after five years, certain qualified distributions1 of earnings and contributions are tax- and penalty-free, including a lifetime limit of up to $10,000 used to pay for a first-time home purchase. (Nonqualified withdrawals of earnings are subject to income tax and a 10% early-withdrawal penalty.)

To establish a Roth IRA, teenagers will first have to file a W-2 or a W-4 and a tax return with the Internal Revenue Service to help prove they earned the income and contributed it to the Roth. Parents and grandparents are, however, allowed to match those earnings dollar for dollar, provided they're kept outside an IRA. Initially, the Roth will need to be set up as a custodial account. When your child reaches the age of majority — 18 or 21, depending on your state — he or she will then assume control of the money. By that time, though, hopefully your young investors will have a solid appreciation of the benefits of saving. "This is all about helping kids get started," Toth says. "What is really powerful about using a Roth in this way is that it can educate kids about the importance of disciplined saving and investing, as well as the value of making ongoing contributions that can compound over many years."

Consider asking your Financial Advisor to walk you and your teen through these illustrations of the value of investment compounding.

Suppose a teen opens a Roth IRA with $2,000 and makes three additional $2,000 deposits during the next three years.

  • If the $8,000 in contributions grows at 6% annually, after 50 years it will be worth $170,832.
  • If the $8,000 in contributions earns an average annual return of 8%, after 50 years it will be worth $456,503.
What if those $2,000 annual contributions continued for 50 years?
  • With 6% average annual growth, the $100,000 in contributions would grow to $615,512.
  • If the contributions compounded at a yearly rate of 8%, the account would be worth $1,239,343.

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1 Withdrawals before age 59½ are subject to a 10% penalty, in addition to any ordinary income tax that may be due. Exceptions to the rule include withdrawals for a first-time home purchase, qualified higher-education expenses, the account owner’s death or disability, IRS levy, SEPPs and certain medical expenses.

The case studies presented are hypothetical and do not reflect specific strategies we may have developed for actual clients. They are for illustrative purposes only and intended to demonstrate the capabilities of Merrill Lynch. They are not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent on your individual facts and circumstances. Results will vary, and no suggestion is made about how any specific solution or strategy performed in reality.

Diversification does not assure a profit or protect against a loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor its Financial Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

For a withdrawal from a Roth IRA to be federally tax-free, it must be considered qualified. There is a five-year holding period when determining whether earnings can be withdrawn tax-free as part of a qualified distribution from a Roth IRA. This period begins January 1 of the tax year of the first contribution or the year of conversion to any Roth IRA. The distribution must be made after the five-year holding period, and the individual must have reached age 59½, be deceased, disabled or use the funds for a first-time home purchase (lifetime limit of $10,000). There is a 10% penalty for nonqualified withdrawals of earnings taken before age 59½, with certain exceptions — higher education expenses; qualified first home purchase (lifetime limit of $10,000); certain major medical expenses; certain long-term unemployment expenses; disability; or substantially equal periodic payments. A special penalty provision applies for converted assets. If a nonqualified withdrawal is made within five years of the conversion, the earnings withdrawn will be subject to income tax, and the entire withdrawal may be subject to an additional penalty unless an exception applies.