If your children or grandchildren are teenagers or young adults, they probably have some earned income but perhaps not very much. If they don’t participate in an employer-sponsored retirement plan, they qualify for a full $5,000 IRA deduction this year, assuming they have at least that much earned income. Even if they are covered by an employer plan, they can take a full deduction with income up to $56,000 in 2011 (assuming they are single taxpayers) and a partial deduction with income up to $66,000.
However, your young relatives likely will be better off putting that $5,000 into a nondeductible Roth IRA. That’s because an IRA deduction probably won’t be very valuable. In 2011, a single taxpayer can earn up to $5,800 and owe no tax at all. Even if the youngster earns more, the tax rate is likely to be 10 percent or 15 percent, which covers taxable income up to $34,500 this year. In a 15 percent bracket, a $5,000 IRA deduction would save only $750.
Suppose your 22-year-old child puts a $5,000 deductible contribution into a traditional IRA that earns 8 percent per year. At an 8 percent annualized rate, $5,000 would compound to more than $90,000, by age 60.
With a traditional IRA, every penny that results from a deductible contribution is taxable upon withdrawal. Your 22-year- old would get an initial tax saving of no more than $750 and wind up paying tens of thousands of dollars in tax when the money is withdrawn, depending on tax rates in the future.
With a Roth IRA, your child or grandchild would not save any tax upfront. However, all Roth IRA withdrawals are tax-free after five years and after age 59 1/2, no matter what happens to future tax rates. So a Roth IRA contribution probably will be a better deal for your young relatives with earned income.
