Retirement is probably not on most teens' radars, but it should be. That’s because a relatively small investment today can grow into a much larger sum later, after decades of compounding. A great place to start is with a Roth IRA.

Key Takeaways

  • A Roth IRA can set teenagers up for a comfortable financial future.
  • Anyone with earned income can contribute to a Roth IRA.
  • Children under the age of 18 need a custodial Roth IRA.

Tax-Free Growth and Income for Retirement

One of the biggest perks of a Roth IRA is the tax break it offers. With a Roth IRA, you don’t get an upfront tax break like you do with a traditional IRA. Instead, your contributions and earnings grow tax-free forever.

This usually works out well for teens. That’s because most teens pay little if any income tax. If a teen has a summer job, or works during the school year, their pay makes them eligible for a Roth. Here's how it works:

  • Any Roth IRA contributions made now aren’t deductible, but the deduction wouldn’t be that valuable anyway. Later, a teen enters a higher tax bracket, they will not have to pay any taxes on that money.
  • Contributions can be withdrawn at any time, for any reason, without owing any taxes or penalties. But the account holder will need to wait until they are at least age 59½ to take out the money the contributions earn in interest if they want to avoid a 10% early withdrawal penalty.

You Can Only Contribute Earned Income

Anyone can contribute to a Roth IRA, regardless of age. That includes babies, teenagers, and great-grandparents. Contributors just need to have earned income for the year they make the contribution.

Individuals earn income when they work for someone else who pays them, or when they own a business or farm. While babies are unlikely to have earned income unless they are child models or actors, the type of work teenagers often do—babysitting, lifeguarding, burger flipping, and so forth—will qualify. Investment income does not qualify.

The contribution limits on IRAs change periodically based on inflation. For 2019 and 2020, workers can contribute up to $6,000 a year to a Roth IRA ($7,000 for those 50 or older). But the contribution can only be as large as the individual's earned income. If a teen earned $4,000 during the year, that is the most they can contribute.

The pay received must be legitimate and at the going market rate. Parents, for example, cannot pay their kids $1,000 an hour to mow the lawn and call it earned income. Ideally, the contributor will receive a W-2 to substantiate their earnings. Otherwise, it’s a good idea to keep excellent records from odd jobs that do not provide a W-2.

Adults Can Contribute to a Teen’s Roth IRA

Parents and other adults can “match” a teen’s earnings and make a contribution themselves. For example, if a teen earns $3,000 at a summer job, their parents can kick in the $3,000 contribution and let their son or daughter spend (or save) their money. Or they could help by contributing a percentage of their teen's earnings—say, 50%.

Parents can contribute the money to a teen's Roth IRA as long as the teen earned at least that much.

The Internal Revenue Service (IRS) does not care who makes the contribution. The teen just needs enough earned income to equal (or exceed) the contribution.

How to Open a Roth IRA for a Teen

An adult has to open a custodial Roth IRA account for a minor. In most states, that’s age 18, but it’s age 19 or 21 in others.

Custodial Roth IRAs are basically the same as standard Roth IRAs, but the minimum investment amount may be lower. Many, but not all, brokers offer custodial Roth IRA accounts. Firms that currently offer accounts for minors include Charles Schwab, E*Trade, Fidelity, Merrill Edge, TD Ameritrade, and Vanguard.

As the custodian, the adult controls the assets in the Roth IRA until the minor reaches the age of majority. At that point, the account belongs to the minor. A minor can continue to invest in a Roth IRA and set themselves up for a sound financial future—as far off as that future might seem.