Grandparents can give a big boost to the finances of their grandchildren who earned money from summer jobs. They can help make contributions to a Roth IRA and begin building a tax-free nest egg.
A contribution to a Roth IRA can be made by anyone who has earned income and whose adjusted gross income is below the limit. Money earned from jobs, operating a business, and performing personal services is earned income. The maximum contribution is the lesser of $4,000 and the amount of earned income for the year. If the grandchild earned $5,000 from summer and after-school jobs, then he or she can contribute $4,000 to a Roth IRA.
The contribution does not have to come from the actual cash from the jobs. That is where the grandparents come in.
A grandparent makes a gift to the grandchild that matches earned income up to $4,000. The grandchild then contributes that gift to the Roth IRA. The gift qualifies as part of the annual $11,000 gift tax exclusion amount ($22,000 if married grandparents give jointly). The grandchild still has the money he or she earned to spend on CDs, movies, clothes, and other things.
The Roth IRA has many advantages. Income and gains earned in the IRA compound tax free. In addition, distributions after age 59½ will be tax free. Unlike a regular IRA, required minimum distributions after age 70½ do not apply. If the grandchild needs the money before age 59½, the contributions can be withdrawn without taxes or penalties. Income taxes will be due if the compounded income and gains are withdrawn before age 59½.
Here’s an example of how this strategy builds wealth.
Suppose a grandchild is 14, and you give her $4,000 to put in a Roth IRA. The investment return on the account is 6% each year. At age 40, the account is almost $20,000. By age 60, it is almost $62,000 – all from your $4,000 gift.
Suppose $4,000 contributions to the Roth IRA are made for four consecutive years, until she graduates from high school. Then, at age 40, the Roth IRA has almost $71,000. At age 60, it is worth over $513,000. That is all from a modest 6% annual return and your $16,000 of contributions.
Remember, the grandchild actually has to make the Roth IRA contributions. You can give him or her the money and help with the paperwork. Some mutual funds and brokers will not set up Roth IRAs for minors, though it is legal for minors to open the accounts and make contributions.