The summer months for many students mean no school, a break from normal routines, late nights, vacations and trips to the pool. Amongst all this fun, many young students use this time of year to earn a few bucks through various forms of part or full-time employment. While seeing their children earn income many parents often ask, “How can I encourage my child to save or educate them on the benefits of saving early?” An idea to help parents answer this question can be found in a strategy that I have termed “A Child’s Savings Incentive Plan”.
Step 1: Determine if your child is eligible to contribute to an IRA. Children of any age can contribute to an IRA if they have earned income from an employer (i.e. lifeguards, camp counselors, etc.). If you can check this box, then they will be able to contribute the lesser of $6,000 or their taxable earnings for the year. For example, if your child earned $2,000 for the year, then they would be allowed to contribute $2,000 to an IRA. If they earned $20,000, then they would be allowed to contribute $6,000.
Step 2: Identify which savings account is best for the child. In my experience, most of the time it is the Roth IRA. Since most kids do not earn enough money to benefit from a tax-deductible contribution, the Roth’s after-tax contribution is often more applicable. Under today’s rules, if a child opens a Roth with an after-tax contribution and holds the account until age 59 ½ any withdrawal will be tax free and the growth will be tax deferred. This is also a great opportunity to educate your child on the power of compound interest or tax-deferred growth!
Step 3: Not all summer jobs are lucrative enough for students to want to open a Roth IRA and defer all or part of what little income they made over the summer into a long-term savings account……I get it! As parents we can incentive savings by offering a “Savings Match” to their account for dollars earned or contributions made. The IRS does not care who makes the contribution to the IRA provided it does not exceed your child’s earned income discussed in Step 1. I work with some parents that choose to match their child’s earnings and make the IRA contribution themselves and others who choose to match any contributions their child makes into their IRA for the year. As a parent this is up to you and what your finances will allow.
Step 4: Have your financial professional or yourself sit down with your child to discuss the above mentioned plan in detail, emphasizing the benefits of saving at an early age, the power of tax-deferred growth, an intro discussion to investing, the type of investment that will be used for the contributions and how the child can follow the investment.
Young people do not often realize how much of an advantage the gift of time is. Too many people overthink the size of the contribution made to an IRA rather than the length of time it will have to grow. Even the smallest of contributions can grow significantly due to the power of compound interest to which Albert Einstein referred to as “The eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.