Our teenage son got his first paying job in summer 2021. After he received his Form W-2 in the mail from his employer, my wife and I decided to explain the form to him and to discuss filing his first federal income tax return. Since we, as his parents, no longer receive any federal income tax benefit from claiming him as a dependent on our tax return, we explained that he should file his own return and claim a refund for the small amount of federal withholdings taken out of his salary. Our son was thrilled to learn that a “bonus” had just fallen out of the sky and into our mailbox, for him.
It gets better, though. We also used this as an opportunity to talk with him about saving for retirement. We explained that since he did not participate in his employer’s retirement plan, he was eligible to contribute to a Roth IRA for 2021 in an amount equal to his earned income. The contribution limitation for Roth IRAs for 2021 was $6,000 for workers under 50 years old (this limitation is indexed for inflation and increased to $6,500 in 2023). Assuming our son earned $2,500 during the summer, he could contribute that entire amount to a Roth IRA. Of course, asking a 16-year-old to put all of his summer earnings into a retirement account he basically cannot access until he is 59½ years old would be a short discussion. However, our son was delighted when we explained to him that we would like to reward his hard work by matching his earnings in a Roth IRA we would set up and fund for him.
We opened a Roth IRA for a minor using my son’s Social Security number and contributed the exact amount of his wages as reported to him on box 1 of his Form W-2 into the account. We were able to wait until he received his W-2 because taxpayers have until April 15 of the year following the year the wages were earned to fund contributions to either traditional or Roth IRAs. Because gifts made by parents to an IRA for their child qualify for the federal gift tax annual exclusion, there were no tax consequences of any kind triggered by this transaction. We chose a Roth IRA over a traditional IRA because our son did not owe federal income taxes for last year’s earnings, so there would be no income tax break should he contribute to a traditional IRA. The Roth IRA option allows the same tax-free buildup as a traditional IRA, but withdrawals by our son will be tax-free from a Roth IRA at retirement, whereas future withdrawals from a traditional IRA would be taxable to him as ordinary income.
Why did we do this for our son? I read somewhere that Albert Einstein was asked about the most interesting phenomenon he had observed as a scientist. His immediate response was, “compound interest.” I like to think that had he been alive today, Einstein’s response would now be “tax-free compound interest.” Let’s assume monies invested at 10% annual interest with a long-term planning horizon double every seven years. When our son is age 65, his $2,500 Roth IRA could be worth $320,000. Assume he works every summer to age 21, and we continue to match his earned income into his Roth IRA. In this scenario, he can expect to have a tax-free retirement account worth close to $2 million when he retires funded entirely by his efforts, and our generosity, prior to age 21. But what else have we done for our son? We have demonstrated the importance we place on hard work in our family by rewarding his earned income. We have leveraged our annual exclusion gifting to him by placing funds into an account that can compound income tax-free over his lifetime. And hopefully, we have started a discussion about the importance of saving for retirement.
