Teens And Roth IRAs: What You Need To Know

When you first start working, it's often difficult to think about long-term investments, especially when you don't feel as though you earn that much money. Nonetheless, some investments are more profitable if you set them up as soon as you start work, so it's a good idea to set up long-term investments as early as you can. Find out how Roth IRAs work, and learn more about the reasons why working teens should consider this type of investment.

How a Roth IRA works

A Roth Individual Retirement Arrangement (IRA) is a type of retirement plan that attracts special tax advantages. Any money you contribute to a Roth IRA comes out of your post-tax salary, so you have already paid tax on the cash. After that, any growth or earnings you make from the plan are tax-free, and any cash you take out in retirement is also free from federal tax.

Eligibility and annual contributions

Only people of a certain income can pay into a Roth IRA, but most teens are eligible.

If you are single and earn $116,000 per annum or less, you can contribute $5,500 into a Roth IRA (based on 2015 income limits). For people who earn between $116,000 and $131,000, the IRS is starting to phase out eligibility for a Roth IRA, and if you earn more than $131,000 you are already ineligible. While marriage is less common for teens, married couples that jointly earn $183,000 or less can also contribute the $5,500 limit between them.

You can't contribute more than you earn. For example, if you only earn $4,000 per year, you cannot pay more than this into a Roth IRA. You can make your annual contribution at any time up to April 15, 2016 to pay into a Roth IRA for the 2015 allowance.

The U.S. Government reviews all eligibility criteria and contribution limits annually.

Advantages and benefits for teens and young professionals

A Roth IRA has several advantages for young investors.

When you first start working, your salary is generally much lower than you would expect as you approach retirement, so you've paid minimal tax on the Roth IRA component (the investment) that attracts tax. What's more, if you leave the money in the Roth IRA for at least five years, you can then take the money out tax-free at any point from the age of 59 years and 6 months.

Perhaps more importantly, a Roth IRA also gives you more flexibility with your investment. You can take your contributions out of the account at any time without paying taxes or penalties. As such, if you want to use some of your contributions to buy your first car, you can do so without a penalty. You can also avoid any early withdrawal penalty on earnings if you use the money you take out to pay for higher education costs or to pay up to $10,000 for your first home.

Conversely, you don't have to make any withdrawals, and you can leave your investment in a Roth IRA for as long as you like. Some accounts force investors to start taking out withdrawals from the age of 70 and 6 months, but this rule doesn't apply to a Roth IRA. As such, this means a Roth IRA is a great choice for estate planning purposes because your dependents won't pay tax on money inherited this way.

Disadvantages to consider

A Roth IRA is not always the best investment vehicle for teens, especially as they grow older and earn more. If you earn too much money straight away, you aren't eligible for the account, and if your earnings reach the limit later in life, you can no longer contribute the annual limit. As such, you may need to change your investment portfolio once you reach a certain earnings threshold.

This type of account is not an effective way to cut your tax liability, either. You make all contributions after necessary tax deductions, so you don't save money on your annual tax bill. What's more, any contributions you make don't lower your gross income, so you can't benefit from other tax breaks. Other accounts may work better for you. For example, a traditional IRA offers these tax breaks, and there are no annual limit contributions. 

A Roth IRA is often an effective way for teens to invest for retirement, but there are pros and cons to consider. Talk to a private wealth management expert for more advice.