Retirement Savings: Opportunities Abound for the Working Next Gen

February 12, 2023
Managing Director Brett Sovine discusses an appealing retirement savings option for working next generation members: the Roth IRA.

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.

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. 

When our son graduates from college and begins his career, I hope that the buildup in his Roth IRA and his understanding of the importance of saving for retirement will encourage him to contribute to the 401(k) plan offered by his employer. We are often asked by our younger clients whether to participate in a 401(k) plan at their first job. Our advice is always to do so and to contribute at least as much as is necessary to secure any matching funds offered by an employer. Doing so locks in a 50% to 100% return on invested (contributed) wages, depending on the terms of the employer match. If the children respond that money is tight as they are starting out, we encourage their parents to reimburse them for contributions to a 401(k) plan via annual exclusion gifts. It works the same as the Roth IRA example explained earlier and sends the same financial message to the adult child about the importance of saving for retirement.

Brown Brothers Harriman (BBH) advises many families on how to take advantage of retirement savings options. These opportunities exist for parents, but also for grandparents who would like to make gifts to their grandchildren. Grandparents can fund Roth IRAs for any grandchild who has earned income and does not participate in an employer retirement plan. It would work just like the example for our son, but my mother-in-law would be out the $2,500 instead of me. In cases where a family owns a business, business owners can hire their children as summer or seasonal employees and pay them to ensure the children have earned income to qualify them to contribute to a Roth IRA.

If your family has questions about leveraging retirement savings, contact your local BBH wealth planner.

Withdrawals of earnings are free from federal income tax, provided the Roth IRA has been in existence for five years and you are at least 59½ years old.

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