If you are the parent of a teen who has just landed his or her first paying job, you have a great opportunity to teach your teen about money management, spending, saving for retirement, and taxes.
But the financial world is more complex than when most parents were kids -- so where do you start? Here's a primer on teen taxes and retirement saving that will help smooth your child's entry into the working world.
A teen job is likely to be your child's first (and no doubt shocking) introduction to the world of taxes. Help your teen maximize job earnings by discussing and encouraging your teen to follow these tax tips.
File a Tax Return
Most teen workers will have some taxes withheld from their paycheck, even if they earn far less than $5,700 a year -- the amount a dependent can earn without paying taxes (2010 figure). This is because employers generally calculate withholding based on an assessment of annual salary, even if the employment lasts for only a few months.
By encouraging your teen to file a tax return, you'll ensure that they don't pay taxes unnecessarily. Most teen workers will get some, if not all, taxes refunded by filing a return. (To learn more about filing taxes, see Nolo's articles Filing Taxes: Top Ten FAQ and Personal Taxes: Overview.)
Keep Track of Tips
Many teen jobs -- waiting tables, for example -- involve tips. Tips are taxable and need to be reported as income, so encourage your teen to keep a log of all tips received. If your teen gives you a face that says, "What, are you crazy, and how would they know, anyway?", explain that keeping a record will avoid the IRS assuming that tax is owed on the basis of the employer's estimate of tips, which will usually be higher than the amount actually received. (To learn more about the rules regarding tips, read Nolo's article Tips, Tip Pooling, and Tip Credits: What Employees Need to Know.)
Complete a W-4 for Every Job
Teens, like other employees, must complete all relevant IRS forms. For example, a teen worker is required to complete a W-4 form (Employee's Withholding Allowance Certificate) for every job held. Tax forms can be accessed online through the Internal Revenue Service website at www.irs.gov.
It's never too early to start saving for the future, no matter how far away it seems. You might mention that even a small amount set aside now can grow significantly as the interest compounds over the years (so that your teen starts earning interest on the interest). The following retirement savings tips can help your teen maximize his or her summer earnings.
Open an IRA
An IRA (Individual Retirement Account) is a type of retirement savings account that you can set up yourself at a bank or other IRS-approved organization. An IRA is a great way to save for the future, offering big tax advantages and the ability to grow money over time. (To learn more about IRAs, see Nolo's articles Retirement Plan FAQ and Saving for Retirement: The Basics for Those Getting Started.)
IRAs are not just for middle-aged workers saving for retirement. A teen who invests a small amount of his of her job earnings in an IRA can reap significant investment returns in the future.
Teen Workers Should Consider a Roth IRA
Retirement savings accounts come in different shapes and sizes. According to some experts, the Roth IRA, as opposed to the traditional IRA, is a particularly good choice for the teen worker because of its tax-free benefits, flexibility, and the fact that it allows parents to make contributions.
Tax advantages of the Roth IRA. Both traditional and Roth IRAs provide tax advantages, but each do so in a different way. With the traditional IRA, contributions are generally tax deductible but you pay taxes when you begin to withdraw the money at retirement (as early as 59 ½ years and no later than 70 ½ years). By contrast, you can't deduct contributions to a Roth IRA, but your eventual withdrawals will be tax free (as long as you are age 59 ½ and have held the account for at least five years).
According to some experts, tax-free withdrawals at retirement make the Roth IRA a particularly good choice for the young investor. Young workers are likely to be in a higher income bracket at retirement, so they'll benefit more from tax-free withdrawals at retirement. And because most teen workers do not make enough money to pay income tax, the traditional IRA's tax deduction for contributions provides little benefit.
The Roth IRA offers flexibility. The Roth IRA offers unusual flexibility in that contributions to a Roth IRA can be withdrawn at any time, tax-free and without paying a penalty. This makes the Roth IRA a particular good choice for the young investor, allowing money to be withdrawn for college or a first-time home purchase.
Parents can make contributions to the Roth IRA. Although the IRS requires the teen worker to have earned income in order to contribute to the Roth IRA, the contributions don't all have to come from the teen's paycheck. For example, if your teen earns $4,000 this year, $2,000 can come from the teen's paycheck and the other $2,000 can be contributed by parents. This is a good way to help your teen's money grow while also encouraging your teen to save.
The rules relating to retirement accounts and taxes can be complicated. For example, not everyone is eligible to open a Roth IRA and contributions are capped. Be sure to do your research before committing to any one particular product.
For more detailed information about opening a Roth IRA, and how the Roth IRA compares with a traditional IRA, get The Busy Family's Guide to Money, by Sandra Block, Kathy Chu, and John Waggoner (Nolo).