Roth IRA for young adults

[Sam]

Please forgive my ignorance.* I am learning about Roth IRA.

I have two kids, 18 and 17.* I would like to start some kind of saving plan for them.* It appears that Roth IRA is proper vehicle at this moment.* I hope the following questions make sense.

1) Does the kid have to have income in order to have a Roth IRA?

2) Assume income is 2K, can contributions to Roth IRA be more than that?* Up to 4K?

3) The kids are my dependents (tax), does that affect anything?

What else should I know about?* What should I look out for?

Thanks,
Sam

[LovesLife]

I'll give it to you in a nutshell and later on someone will come up with the IRS pub, I'm sure.

You can open ROTH IRA's for your kids as long as they have earned income. You can only contribute up to the amount of the earned income. Any child under age 18 will be listed as a minor on the account. Their contributions should not affect your income tax.

[2B]

Originally Posted by Sam

Please forgive my ignorance.* I am learning about Roth IRA.

I have two kids, 18 and 17.* I would like to start some kind of saving plan for them.* It appears that Roth IRA is proper vehicle at this moment.* I hope the following questions make sense.

1) Does the kid have to have income in order to have a Roth IRA?

YES

2) Assume income is 2K, can contributions to Roth IRA be more than that?* Up to 4K?

THEY CAN ONLY CONTRIBUTE UP TO THEIR INCOME.

3) The kids are my dependents (tax), does that affect anything?

NO

What else should I know about?* What should I look out for?

IT'S A GREAT WAY FOR THEM TO START BUILDING A NEST EGG. YOU DON'T HAVE TO REPORT RETIREMENT PLANS WHEN APPLYING FOR COLLEGE SCHOLARSHIPS. IF YOU'RE WANTING TO HELP THEM START SAVING, THIS WOULD BE A GREAT WAY TO DO IT.
Thanks,
Sam

[jdw_fire]

As LL said they can only contribute EARNED income up to the max contribution.

[Martha]

Did someone say pub?

http://www.irs.gov/publications/p590/index.html

[Nords]

Originally Posted by Sam

I have two kids, 18 and 17.* I would like to start some kind of saving plan for them.* It appears that Roth IRA is proper vehicle at this moment.* I hope the following questions make sense.

Pub 590 says it all, except for one little surprise that almost got me.

At least one of your kids will be making before-tax contributions to the fed's Thrift Savings Plan.* The contributions are deducted & sent to the TSP before they're counted as earned income.

So if your kid earns $4000 and contributes $500 to the TSP, then their W-2 earned income will only be $3500 and their max IRA contribution will also be $3500, not $4000.

And now here's a completely different thought.* The max annual TSP contribution (this year) is $15K and the max IRA contribution (under age 50) is $4000.* Instead of gifting cash to kids, two parents could gift the max to their kid's tax-deferred savings accounts-- up to $19K or the limit of the kid's earned income, whichever's lower.* Since the money doesn't technically become spending cash, they'll have that much less incentive to see it burning a hole in their pocket.* If they wanted to make a withdrawal for tuition or a house down payment, some amount could be withdrawn without penalty.* Otherwise they could leave it in the account for 40-50 years of tax-deferred compounding.

I've glossed over a lot of the rules & limits, but the outline seems legal and the compounding math is certainly compelling.* So instead of giving cash or possessions to our kids, perhaps we benevolent parents should be ensuring that they totally max out all tax-deferred savings programs to their limits.

This doesn't solve the EOC or affluenza problems.* But it sure boosts the kid's retirement savings program.

[free4now]

One thing to watch out for is that the principal in a Roth IRA can be taken out at any time for any reason with no penalty and no taxes. So if you contribute $4k when the kid is 17 years old, a year later when they are legally of age they can take $4k out and go to Mexico for a trippy spring break.

Most adults don't know they can take out their principal without restrictions, and most kids probably have no clue. I suppose at least they would have to do some serious studying about Roth IRAs to learn how to blow it.

[Sam]

Thank you all for your replies.* You folks are great and quick.

Since my kids' income for the next 4 years are low, less than 5K each annually, they won't owe any federal income tax.* Therefore, it's better to contribute into Roth IRA, rather than IRA, TSP, 401K.* Am I correct?

Sam

[Nords]

Originally Posted by Sam

Therefore, it's better to contribute into Roth IRA, rather than IRA, TSP, 401K.* Am I correct?

If they think there's a chance over the next 20 years that they'll want the money back, for example a house down payment or to pay for that shore-duty MBA, then a Roth gives the most flexibility. That's probably their primary concern right now, although if they can fully fund the Roth then there's a lot of room left over for TSP/401(k) contributions.

The problem is that the TSP/401(k) contributions can only be made out of each paycheck, not in a lump sum. Roth contributions have much more flexibility, of course.

But expense ratios matter. For a sucky 401(k) with no match and high fees it might be better to stay with a Roth. Conversely it's really really hard to pass up a TSP expense ratio of 6-7 basis points. Every penny of Reserve income that my spouse used to make went into the TSP (after SS/Medicare deductions), and it's ironic that her income stopped just as the TSP opened the contribution limits from 10% to the IRS limits...

Hey, why are we wasting our time preaching about this to you, who's probably already a member of the choir? I sure hope your kids are reading this board or getting the same type of info from other websites/books...

[Sam]

Originally Posted by Nords

But expense ratios matter.* For a sucky 401(k) with no match and high fees it might be better to stay with a Roth.* Conversely it's really really hard to pass up a TSP expense ratio of 6-7 basis points.* Every penny of Reserve income that my spouse used to make went into the TSP (after SS/Medicare deductions), and it's ironic that her income stopped just as the TSP opened the contribution limits from 10% to the IRS limits...

Thanks for the input, Nords.* But, I'm lost here.* What expense ratios are you referring to?

Originally Posted by Nords

Hey, why are we wasting our time preaching about this to you, who's probably already a member of the choir?

What choir?* I don't even know how to sing*

[jdw_fire]

The expense ratios of what ever investment you put the money that is in the Roth into.* The TSP's imvestments (eg. the C fund) have a very low expense ratio.* When choosing between investing in a Roth and a 401k/TSP you also need to consider any matching funds provided by the 401k/TSP since that match greatly improves your return.

[Sam]

Thanks jdw_file.

[FlowGirl]

Originally Posted by Nords

The problem is that the TSP/401(k) contributions can only be made out of each paycheck, not in a lump sum.* Roth contributions have much more flexibility, of course.

Yes, this is why we always take care of TSP first.* Although it's a little more flexible now that the percentage limits are gone - we're planning to have our TSP maxed out for the year by the end of next month.* Spouse is deploying to tax free zone later in the year and we wanted to make sure that TSP came out of taxable pay.* After that we'll take advantage of the military's Combat Savings Deposit Program (10% interest up to $10K)* and still have until April 15 of the following year to fund an IRA.*

TSP is also simple.* It only takes about 5 seconds to log onto the mypay website and start or change your contribution.

[Nords]

Originally Posted by Sam

Thanks for the input, Nords. But, I'm lost here. What expense ratios are you referring to?

There are a number of funds in the Thrift Savings Plan investing in different assets, but the thing they all have in common is an expense ratio of about .06-.07%.

http://www.tsp.gov/forms/comparison.pdf

Hunh-- haven't looked at that link in a while, and it looks like the ERs are down to 5-6 BPs...

Originally Posted by FlowGirl

Spouse is deploying to tax free zone later in the year and we wanted to make sure that TSP came out of taxable pay.* After that we'll take advantage of the military's Combat Savings Deposit Program (10% interest up to $10K)* and still have until April 15 of the following year to fund an IRA.*

I read on Military.com that a lot of military are overcontributing to their IRAs because they're earning mostly tax-free pay. I guess that doesn't show up on a W-2 and so it appears that they don't have enough earned income to match the contributions they made.

So you're smart to wait until 2007-- after you've checked your 2006 W-2. What a problem to have to deal with, eh?

It was fun while it lasted, but from this perspective I'd rather pay taxes than earn combat/hazardous duty pay.

[Sam]

Thanks again Nords.* I was confused because I thought a "basis point" is 1% * Just another terminology mixup on my part.

[Nords]

Originally Posted by Sam

Thanks again Nords.* I was confused because I thought a "basis point" is 1% * Just another terminology mixup on my part.

Sorry-- 100 basis points for every per cent.

Bond sales staff have to have their own language or just about anybody would understand the process. Me, I'd rather have a high-equity portfolio than to try to deal with things like "convexity", "credit swaps", and "reverse repos"...

[FlowGirl]

Originally Posted by Nords

So you're smart to wait until 2007-- after you've checked your 2006 W-2.* What a problem to have to deal with, eh?

Yes since we don't know exactly how much tax free income we'll earn this year or next.* Also if spouse deploys later rather than sooner,* we want to lower our taxes and make sure we qualify for the max saver's tax credit.* TSP contributions made out of* a tax free paycheck won't help lower our taxable income for the year.*

And if that weren't enough... an additional benefit is that it also frees up cash for the Combat Savings Deposit Program.* As you probably know -contributions to SDP are limited each month to your pay minus your deductions - so even if you have $10K lying around you can't put it in all at once.* Without a big chunk coming out for TSP each month we can make bigger contributions and have that money earning a guaranteed 10% that much sooner.

I definitely agree - I'd rather be paying taxes, but it sure is fun making our $100K income look like $20K or less to the tax man.* We plan to wring as much money out of the situation as possible.

[Nords]

Originally Posted by FlowGirl

We plan to wring as much money out of the situation as possible.

I just got this in MOAA's weekly e-mail:
"Combat Troops' IRA Rights To Be Restored
A week after House passage, the Senate acted on May 18 to approve legislation (H.R. 1499) that will ensure combat troops won't lose the right to contribute to individual retirement accounts (IRAs). The bill will now go to the president for signature.
At the urging of MOAA and others Congress passed H.R. 1499, originally introduced by Rep. Virginia Foxx (R-NC), to fix a situation in which servicemembers assigned to combat zones effectively can be barred from making contributions to IRAs under current law, since their basic pay is exempt from federal income taxes. With no taxable earned income, they fail to meet eligibility rules for IRA contributions.
This legislation will ensure that servicemembers who are sent in harm's way won't be penalized in their ability to build future retirement savings."

I don't know if this is retroactive or starts in 2007, but I guess you'll want to keep an eye on MOAA or Military.com for more tax-planning info.

[Nords]

Hey, FlowGirl, check this out-- it's retroactive:

President Signs Legislation Allowing Tax-Advantaged Savings for Troops
On May 29, the Heroes Earned Retirement Opportunities (HERO) Act, which ensures that no servicemember loses the opportunity to contribute to individual retirement accounts (IRA), was signed into law by President Bush.

The House and Senate acted rapidly on the measure, passing it within a week of each other in mid-May, after it was originally introduced as H.R. 1499 by Rep. Virginia Foxx (R-NC).

At the urging of MOAA and others, Congress passed H.R. 1499 to fix a situation in which many servicemembers assigned to combat zones effectively were barred from making contributions to IRAs under current law, since their basic pay is exempt from federal income taxes. With no taxable earned income, they didn't meet eligibility rules for IRA contributions.

Personnel serving in Iraq and Afghanistan will now have the same ability to contribute to their retirement savings that other Americans enjoy. The new law also is retroactive to cover tax years 2004 and 2005, so affected members who previously were kept from contributing in those years may now make retroactive contributions and file amended tax returns.