How to Turn a Summer Job into a Tax-Free Retirement Nest Egg and More
‘Tis the season for summer jobs for high school and college kids. These seasonal jobs are more than just an opportunity for teens and college students to earn some money and gain experience. They also provide the opportunity for seeding a significant retirement nest egg and even a down payment on a home through a Roth IRA.
Seems too good to be true? Well, it’s not – but as always, the devil is in the details, and it is not exactly a free lunch. So, let’s walk through exactly how this all works.
Step 1 – Earned Income
First, teen or college students must get a job that pays – and the more the better. This is because the gateway to opening and contributing to a Roth IRA is earned income. The magic number for earned income to max out a Roth IRA in 2021 is $6,000, as this is the contribution limit. This is because contributions are limited to the lesser of the $6,000 limit or 100 percent of earned income.
Step 2 – Make the Roth IRA Contributions
The next step is to make the contributions to the working child’s Roth IRA. Let’s be honest here. It is a rare case where a kid is going to take all or nearly all their summer job earnings and stash them away in a Roth IRA for 50+ years down the road. There is a way around this, however.
A parent or grandparent can contribute to the Roth IRA in the child’s[h1] name, with two nuances. First, this contribution is still governed by the earned income limits discussed above. Second, these amounts count toward the $15,000 per year gift tax exclusion ($30,000 if married) so it will eat into that. Lastly, do not forget the deadline to make 2021 Roth IRA contributions of any type is April 18, 2022.
How Much is This Worth?
While $6,000 or so may not seem like a lot, it can make a significant difference over time due to the power of compounding returns from such a young age – coupled with the tax advantages of a Roth IRA.
To illustrate the power of this tax and investment move, let us take a scenario where a high school kid makes the $6,000 per year over three summers from age 16-18 before heading off to college, and the Roth IRA contribution is maxed out.
With contributions at just $18,000 and NEVER putting in another dime again, this will turn into the following amounts under different assumed investment returns by the time they are 66 (40 years of compounding).
- 6 percent return = $313,000
- 8 percent return = $783,000
- 10 percent return = $1.93 million
Now, before you get too excited, you must understand that 40 years from now $300,000 will not be what it used to be if inflation continues at historical rates – but the point remains. This simple move made over just a few years can create significant tax-free wealth.
Due to the characteristic of a Roth IRA, the other beneficial options relate to withdrawal. First, the contributions can be accessed any time before age 59 ½ without penalties or taxes. Second, even after all the initial contributions are removed, a first-time homebuyer can take up to $10,000 without the 10 percent early withdrawal penalty to help fund the purchase, although they will owe income tax on the withdrawal if it has been less than five years since the initial contribution.
Be VERY careful here though, because any withdrawals will dramatically lower the investment returns noted above.
Funding a Roth IRA for a high school or college child or grandchild can give them a tremendous head start in life. A few years of relatively small contributions early on can create substantial wealth over time due to compounding of returns and the tax advantages of the accounts.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.