Summer is here and, as usual, Oklahoma teenagers are happy to take a break from school.
Usually, teenagers find summer jobs to pay for their short-term desires, like going to Frontier City or going to the movies. Naturally, most teens won’t be interested in saving their money in the long run, but the potential benefits of doing so are enormous. Teenagers have a unique investment advantage that is not available to most working people. This advantage is time.
Most teens will find that the best vehicle to use to invest their money is a Roth IRA because it offers favorable tax relief.
Although there is no initial tax deduction, earnings and contributions will grow tax-free forever. This provides a better tax advantage for teenagers because when they are older they will likely move to a higher tax bracket.
A Roth IRA is potentially a form of tax arbitrage. Your teenager is probably in the 10% tax bracket right now, and expect them to move into the 24% tax bracket in the future when they’re older. This makes the final tax benefit stronger than an initial tax benefit, because paying a little tax now will save a lot more tax later.
Let’s say your teenager is 15 and contributes a maximum of $6,000 to a Roth IRA this year, plus the next three years, until age 18, for a total of $24,000 in contributions.
Let’s further assume that the money will be invested in a diversified index fund and earn an annualized return of 8% until age 65, by which time the Roth IRA will have reached over $1.2 million!
Although an 8% return is not guaranteed, historical data suggests that an 8% return is reasonable for stocks over a long period, given that the S&P 500 Index has generated a return of approximately 10 % annualized since 1926.
This hypothesis demonstrates the awesome power of compounding and is why Albert Einstein was quoted as saying, “Compound interest is the eighth wonder of the world”. When you combine time and capitalization, it’s like rocket fuel for long-term investment growth.
You may be wondering if it’s a good idea to let your teen manage their own investment account.
By law, teenagers are required to have a Roth IRA in custody in Oklahoma until age 18 because they are minors. This means that the parent is responsible for managing the account until the teenager comes of age. Most custodians will allow you to open a Roth IRA custodian, so you should have no problem finding a financial institution to do this for you.
What if your teen wants to spend some of their money on short-term goals or needs?
Generally, you want to avoid withdrawing funds from a Roth IRA before age 59½, which is the earliest age at which you can withdraw funds tax-free. Fortunately, Roth IRAs allow you to withdraw your contributions at any time without any taxes or penalties.
Plus, there’s additional flexibility for college-related expenses or first-time home-buying expenses. You can withdraw funds from a qualified Roth IRA education expense without any 10% tax penalty, but beware, there are taxes on income.
Plus, you can withdraw up to $10,000 for a down payment or closing costs on a home without any penalties or income taxes.
Be sure to consult your tax and financial advisors before taking any action with Roth IRA contributions or withdrawals.
So, as your teen plans to earn money through summer jobs, help them take advantage of this once-in-a-lifetime investment opportunity. By starting early, your teen will be set for long-term financial success and establish healthy financial habits at an early age.
Kendall King is the founder and CEO of Castlepoint Wealth Advisors in Oklahoma City.