You're in High School and Starting an IRA

TheStreet.com

NEW YORK (TheStreet) -- The other day we talked about how a young person can best handle earnings from a summer job, concluding that in today's low-interest world a simple checking account, chosen for convenience rather than interest earnings, would work well for cash likely to be spent within the next few years.

But what if a high school or college student is capable of setting money aside for the long term -- as in saving for retirement?

Thoughts of saving for needs 40, 50 or 60 years in the future can make a teen or 20-something gag. But with the first true "earned income," as opposed to allowance or birthday gifts, comes the opportunity to open an IRA that could produce stupendous gains over such a long investing horizon.

The first objection: The young earner may want to spend the money or save for a more immediate goal, such as buying a car. But generous parents or grandparents (or anyone else, for that matter), can get around that by replacing money the young person contributes to the IRA.

Also see: The New Grads' Guide to 401(k)s

That term "earned income" is important because IRA contributions cannot exceed the amount the plan beneficiary earns from a legitimate job. Parents cannot contribute on the young person's behalf. That's why it's nearly impossible to set up an IRA for an infant.

Earned income, for example, is wages reported on a W-2 form. A W-2 is not necessary, though, if good records are kept. The pay must be at a going rate. Parents, for example, cannot get away with paying their kid $1,000 a week to feed the dog. Investment gains do not count as earned income.

In most states, an IRA for a person under 18, 19 or 21 must be set up as a custodial account managed by an adult. For this year, the maximum contribution allowed is the beneficiary's earned income or $5,500, whichever is less. Most banks, brokerages and mutual fund companies offer custodial IRAs, and many have very low minimums to start an account -- as little as $100 in some cases.

IRAs come in two flavors, traditional and Roth. With a traditional IRA, the account holder may be eligible for a tax deduction on contributions. After that, investment earnings are tax deferred. Income tax on contributions and gains is not due until money is withdrawn, which is generally not before age 59.5.

Also see: 8 Pieces of Advice Grads Will Need for the Rest of Their Lives

With a Roth, there is no deduction on contributions, but all withdrawals, including contributions and investment gains, are tax free.

The Roth, then, is generally the best choice for a young person. The summer job generally pays so little as to leave the young worker in the zero percent tax bracket. That makes the tax deduction on contributions to a traditional IRA worthless. It also makes the lack of a tax deduction on a Roth contribution irrelevant. So the Roth comes out on top due to the tax-free treatment on withdrawals. The investment can compound for decades without a cent ever paid for taxes.

Remember that a single person can have multiple IRAs, and can mix the two types. Later, when income is higher and taxes are a consideration, it might make sense to open a traditional IRA.

How should IRA contributions be invested? Unless the young person, or one of the parents, is an adept investor, the easiest option is a target-date retirement fund. Choose a fund keyed to the year you're likely to retire (or as close as you can get), and the fund company will select an appropriate mix of holdings.

Generally, that will mean mostly stock-owning mutual funds. Over long periods they tend to provide bigger returns than bonds, and with 40 or more years to retirement a young person will have plenty of time to ride out any downturns. As the account holder gets older, some of the holdings will be switched to bonds for an added degree of safety.

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