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Gift a Roth IRA to the Young Adult in Your Life

A teenager on the cusp of adulthood is likely thinking about where to go to college and which friends will be invited to their 18th birthday party, not saving for retirement. So if your child or grandchild asks for a car in celebration of this milestone, and you offer to fund a Roth IRA on their behalf instead, be prepared for some blowback. But don’t let that discourage you.

Named for Senator William Roth, the chief sponsor of the 1997 legislation that created it, the Roth IRA is a savings vehicle that provides a tax break once its owner reaches retirement age. Opening a Roth IRA is almost certainly not on your young relative’s to-do list – which is why funding this type of account is such a generous gift. It’s a way to help a young adult build savings and develop financial savvy that will last a lifetime.

How a Roth IRA Works

A Roth IRA functions similarly to a traditional IRA (individual retirement account): It’s an account that’s used to save for retirement. Contributions to both types of IRAs must be taxed. It’s when those contributions are taxed that primarily sets these products apart.

With a traditional IRA, contributions are made with pretax dollars. You may be able to deduct any contributions on your tax return in the year that the contributions are made. When you reach retirement and start withdrawing the money, you’ll pay income tax on it at that point. Because many retirees are in a lower tax bracket than they were while working, investing with a traditional IRA sometimes works out to be advantageous.

By contrast, a Roth IRA’s contributions are made with after-tax dollars. You can’t deduct these contributions on your tax return but assuming certain conditions are met, the beneficiary of a Roth IRA can withdraw the money tax-free during retirement.

Why Roth IRAs Makes Sense for Young Adults

The longer a Roth IRA has to grow, the better. That’s one of the reasons that this type of account is so well suited as a gift for high school grads. Even if it’s started with a modest sum and then remains untouched, a Roth IRA has the potential to balloon into a substantial nest egg. 

But gifting a young adult with a Roth IRA isn’t just about setting them up for a comfortable retirement 50 years down the road. It’s also a way to help them develop a meaningful understanding around financial planning and investing. This type of account provides an introduction to the wonders of compound interest. Showing a young adult how even modest investments can more than triple over decades is a powerful way to motivate them to make thoughtful choices around saving and spending.

Initiating a Roth IRA now also sets up the recipient for future contributions. If you make the first contribution as a gift marking a child’s high school graduation, you and other relatives might make additional contributions upon college graduation or milestone birthdays. (It’s also worth noting that having a Roth IRA won’t affect a young adult’s eligibility for federal financial aid.)

What You Need to Know About “Gifting” a Roth IRA

Like traditional IRAs, Roth IRAs are subject to IRS rules. There’s a yearly cap on contributions. It’s $6,000 for account holders younger than 70, as of 2019, but marital status and income also come into play. Contributions may not exceed the account holder’s taxable income for that year. So if you wanted to make a $3,000 contribution to your child’s Roth account but he only earned $1,800 that year, the maximum amount you could contribute would be $1,800.

One of the most important things to know about giving the gift of a Roth IRA is that it’s not something you can do as a surprise. The person who will be the account holder has to open their own account and sign the associated paperwork. You can propose the idea and fund the account, but the target of your generosity has to be part of the process.

Finally, it’s important to understand that the account holder can access and withdraw their money at any time, though doing so before the age of 60 will generally involve penalties. That can be tempting for a 20-something who’s struggling financially and needs cash. That’s why it’s essential to involve financial planners who can show the account holder how their money will grow, and prepare them to make the best possible choices around a Roth IRA.

If your child or grandchild is approaching adulthood, helping them establish a Roth IRA could be the most lucrative gift you ever give them. The advisors in our financial planning department can help you make that gift. How can we help you set up your loved ones for a secure financial future? Contact us today!