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Retirement Perspectives

With millions of millennials and centennials still learning about thrift, it’s time to revisit the benefits of establishing a Roth IRA.

Let’s face it: a Roth IRA may not be on a child’s wish list. In fact, most aren’t aware they are eligible. So, it’s up to parents and grandparents to educate the young about the power of a Roth IRA. After all, a Roth IRA carries the potential for future tax-free income, which could make it the gift a lifetime for a child, teenager, or young adult. 

Did you know that there is no minimum age in the tax code to be eligible to establish a Roth IRA? Instead, all that’s required is reportable earned income (such as that reported on a W-2 or self-employment income), and income cannot exceed the Roth contribution limits. Minors can establish a Roth IRA as soon as they start earning income, but few are likely to consider it, much less want to save their hard-earned money for a retirement that seems so far away in time.

That’s where a generous relative (or anyone, for that matter) comes into the picture.  A Roth IRA can be established on a child’s behalf by a family member who can fund that account in the amount equal to the amount earned by the youth during the year, up to $5,500.

Start a Roth IRA as Soon as a Child Has Any Earned Income
Establishing a Roth IRA for a child that has earned income can be very attractive—for parents and grandparents alike.

To illustrate how parents can set up and fund a Roth IRA on behalf of their kids, let’s suppose that Jill, 15, made $2,500 as a lifeguard last summer (2017). Jill’s parents can set up and fund a Roth IRA (up to a maximum of $2,500) on her behalf. The assets will grow tax-deferred for decades, and the proceeds, including earnings, can potentially be withdrawn tax-free.

Yes, Jill can spend her hard-earned paycheck, while at the same time Mom and Dad can fund a Roth account on her behalf. In other words, parents may choose to match their child’s earnings, as long as their contribution does not exceed $2,500, the amount Jill earned for the year. (For instructions on reporting and paying tax on Jill’s income, see IRS publication 929, “Tax Rules for Children and Dependents.”)

Keeping (and Staying on) Track
It’s crucial, however, that someone keep detailed records of all contributions made to the Roth account.  Why?  The rules allow for Roth contributions (e.g., basis) to be withdrawn tax- and penalty-free at any time, regardless of whether the “five-year” holding period has been met. Since distributions of Roth IRA contributions generally can be withdrawn without being subject to income tax at any age, there are variety of ways a teenager or young adult can use the funds.

Whether or not your Roth IRA withdrawal—is taxed depends on a few factors. In general, you can withdraw your contributions (that is, a sum equivalent to the amount you’ve invested in the Roth IRA) at any time without tax or penalty. If the withdrawal is made before age 59½ and includes earnings, then you may have to pay both income tax and a 10% penalty. There are certain situations under which the IRS will allow you to withdraw without penalty.

Here are some common examples:

Higher education—A young adult can take a tax- and penalty-free distribution of Roth IRA contributions (basis) to help offset expenses related to higher education. In addition, an exception applies to the 10% early distribution penalty for such expenses.

Tip: Retirement accounts are not considered assets on the government’s Free Application for Federal Student Aid (FAFSA), thus the value of your Roth IRA won’t hurt your chances for qualifying for financial aid. However, when taking a Roth IRA distribution to pay for college, it may be counted as untaxed income on the FAFSA.

Housing—Roth IRA funds could help to pay for a first home. As previously discussed, Roth contributions can always be distributed free of tax and penalty. Interestingly, if you’re an eligible first-time homebuyer, you can withdraw up to $10,000 in earnings from your Roth IRA without the 10% early-withdrawal penalty, even if you’re under age 59½. You’ll also avoid a tax bill on that withdrawal if you’ve had a Roth IRA for at least a five-year period. If you don’t meet the five-year test, you will be subject to taxes on $10,000, but not the 10% penalty.

Many parents and advisors may not have considered this technique due to a myriad of factors. Most important, not all IRA custodians permit (or are aware) that minors can establish an IRA. Check with your custodian prior to establishing an account. (Tip: Lord Abbett permits minors to establish an IRA.) Further, financial institutions typically do not permit minor children to open a Roth IRA on their own.

Fortunately, many IRA custodians allow parents to serve as guardian on a Roth IRA for the benefit of their children. However, when the minor attains the age of majority, typically 18, ownership of the Roth IRA would revert to the child (as an adult). The child then can make transactions on the account without parental consent.

Of course, much depends on a child’s maturity, financial literacy, and commitment to save for their future. With that in mind, parents (and other adult benefactors) might want to have recurring conversations about thrift when the kids are younger in order to be reasonably comfortable that the child will honor the intent of the Roth.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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