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How to turbocharge your kids' earnings from babysitting and other jobs

A custodial Roth IRA has no age restriction, meaning children can get a head start on retirement and learn about the power of compound interest.
Important Money Management Lessons for Kids
Do your kids earn money for yardwork, snow shoveling, tutoring and other jobs?kate_sept2004 / Getty Images stock
/ Source: TODAY

When it comes to retirement, the earlier you start saving, the better off you'll be. With a Roth individual retirement account, people can start saving long before entering the workforce: Financial experts explained to TODAY that parents can open custodial Roth IRAs for their children once they start earning an income.

Roth IRAs are retirement accounts to which you can contribute any money made after taxes. Contributions and earnings grow tax-free, and money can be withdrawn from the account without any taxes or penalties once the account holder is 59 1/2 years old and the account has been open for five years.

"Roth IRAs are great investment vehicles for kids. There's no age restriction to setting one up; the only restriction is income. ... Basically, the child needs to have some sort of income," said Jordan Wexler, CEO of EarlyBird, an app focused on helping children invest, noting that activities like babysitting or mowing lawns for neighbors would be great ways for kids to get started. "You can participate in very healthy work habits and then invest that as earned income into a Roth IRA."

Investing early in a Roth IRA is key since there's a limit on how much you can contribute per year: The 2020-2021 cap is $6,000. And as your earning power grows over the course of your career, you could hit Roth IRA income limitations: A single person filing taxes must have a modified adjusted gross income of less than $139,000 in 2020 and $140,000 in 2021 to contribute to a Roth IRA. Married couples filing jointly must have a modified adjusted gross income of less than $206,000 for the tax year 2020 and 208,000 for 2021. Parental income doesn't factor into eligibility for custodial Roth IRAs.

One thing that complicates setting up a custodial Roth IRA is that kids need to be able to show a paper trail of where they're making money, and the income will need to be declared on a tax return.

"There really is no minimum age that a child can actually file a tax return," said Lauren Silbert, vice president and general manager of The Balance, a personal finance website, and a personal finance expert, explaining that as long as you're making more than about $1,100 in a year, you can file taxes. "Once you make that, that enables you to file your own separate tax return as a dependent."

Both Silbert and Wexler said that a major benefit of setting up a custodial Roth IRA is helping your child establish healthy money habits as well as teaching them about investment early in life.

"One of the most important lessons you can teach your kid is the power of compound interest," said Silbert, who added that someone who opened an account with $100 and added $20 a month to it for the rest of their working life could have almost $94,000 in that account by the time they retired, despite only contributing about $12,000. "Teaching kids that there is a way to generate income that doesn't require you actually working is a really valuable lesson."

"The foundation of a healthy financial future is understanding investing, and Roth IRAs offer a really great entry point to understanding making money and spending and budgeting, and introducing the idea of compound interest and being able to put money away," Wexler said.

During the coronavirus pandemic, financial health has been more important than ever. Silbert said that this could be another opportunity to teach kids about the importance of saving and investing.

"Given the nature of retirement accounts, you’re not planning for the short term. So every day, month and year you can be invested and take advantage of compound growth the better, even if that means only setting aside $100 at a time," Silbert said. "If you’re financially able to, and your child is earning an income, start an account for them as soon as possible."

Wexler said that another benefit of a custodial Roth IRA is the flexibility offered by that type of account. Once the account has been open for five years, account holders can withdraw up to $10,000 in earnings with no penalty, and there's no obligation to contribute every month or pay a certain amount.

"There's nothing forcing you to make contributions," Wexler said.

Silbert recommends that parents who do set up a custodial Roth IRA take time each month to show kids how their money is being saved and increasing with interest, which can help establish an interest in finance at an early age.

"Every step they take towards their financial security is going to be helpful for them," Silbert said. "Understanding how to budget, how to save for goals and expenses, how to invest, and what that can do to their finances really just gives people a lot of confidence as they move through life. Setting your child up with a Roth IRA as soon as you possibly can is only going to help them be more confident in their financial life later on."

Silbert said that it is important to teach kids about financial security if you set up a Roth IRA for them, since there are no safeguards that a parent or account holder can place on a custodial Roth IRA that prevents a child from withdrawing the funds once they turn 18 or 21. (The age of when a custodial Roth IRA transfers to a child depends on state rules. Some states also transfer control of the account automatically, while other states require parents to initiate the transfer.)

"Hopefully ... parents can emphasize the importance of not touching the investment," said Silbert. "Using an investment calculator to demonstrate how much the account could be worth at the time of their retirement may help convince them. If you placed $1,000 into a Roth IRA for your teenager today, assuming they earned an average of 8% returns, the account could grow to over $100,000 by the time they retire — but only if they don’t withdraw the money!"

Account holders can also only withdraw the contributions they've made without penalty. Taking advantage of any growth or interest gained before the age of 59 1/2 will lead to early withdrawal penalties.

Wexler said that Roth IRAs are just one way parents can prepare their kids for financial success. Setting up a 529 plan, which is a savings plan designed to encourage saving for future education, can help them afford college in the future. A custodial investment account is another way to make sure they're financially stable later in life.

"That fully covers someone," said Wexler. "With a custodial investment account, you get the ability to spend for important things like housing, 529 plans cover them for education, and (with a Roth IRA) they have a retirement account. They have security."