Tax Tip No. 8: Fund a Kid's Roth IRA

The holidays are fast approaching, and you're wondering what to get your favorite teenager. Rather than shopping for the latest trendy fashion or iPod accessory, why not consider 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 2007 because only people with earned income can contribute to an IRA. (Investment income doesn't count.) So, if your teen made money delivering papers, babysitting, flipping burgers, or working any after-school or weekend job, he or she qualifies.

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

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This year, individuals can put up to $4,000 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 assume 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 added another $1,000 a year until she turned 20 -— and never added another dime -- that initial $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 With a Roth IRA, the full amount will be tax-free when it's withdrawn in retirement.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 will help them realize more immediate goals. Since contributions are made with after-tax dollars, they can withdraw the contributions (but not earnings) any time, tax free and penalty free. And when it comes time to buy her first home, for example, she can withdraw up to $10,000 (including earnings) tax free and penalty free. It's hard to think of a better gift this holiday season.

Return to: 15 Year-End Tax Moves