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Why Your Kids Need a Roth IRA

By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance, Source: Kiplinger Consumer News Service

The holidays are fast approaching, and you're wondering what to get your favorite teenager. Rather than shop for the latest trendy fashion or iPod accessory, why not give a gift that could secure his or her future? Consider funding a Roth IRA for your child or grandchild.

For this to work, the child must have had a job in 2009 because only people with earned income can have an IRA. (Investment income doesn't count.) So if your teen made money delivering papers, baby-sitting, flipping burgers, or working any other after-school or weekend job, he or she qualifies.

And nothing in the rules says that the child's own money has to go into the IRA. It's fine with the IRS if you give your son, daughter or grandchild the cash. The key is that no more can be contributed to the Roth IRA than the worker earned on a job.

This year, individuals can put up to $5,000 into a Roth IRA. Even a small contribution now can add up to big bucks in the future, thanks to the power of long-term compounding.

Let's say you give your 15-year-old daughter $1,000 to fund a Roth IRA. If the money inside the account grows at an annual average rate of 8% -- well below the long-term average return for stocks -- that $1,000 will grow to about $47,000 over the 50 years it takes for today's teen to reach retirement age. If you put in another $1,000 each year until she turns 20 -- and then never add another dime -- that $5,000 investment would be worth nearly $250,000 by her 65th birthday. With a Roth IRA, the full amount will be tax-free when it's withdrawn in retirement.

In addition to setting your kids on the road to retirement security, the gift of a Roth IRA can help them realize more-immediate goals. Because contributions are made with after-tax dollars, they can withdraw the contributions (but not earnings) anytime, tax- and penalty-free. In addition, once the account has been open for five years, up to $10,000 of earnings can be withdrawn tax- and penalty-free if the money is used to buy a first home. It's hard to think of a better gift this holiday season.

All contents copyright 2008 The Kiplinger Washington Editors, Inc.