Dear Savvy Senior

Is there a way that we can put some money in a Roth IRA account for our young grandkids to use for retirement?

– Curious Granddad

Dear Curious,

There sure is! Funding Roth IRAs for your grandkids when they’re young is a smart move and an incredible gift to their financial future. And you don’t have to be rich to do it, either. Here’s what you should know.

Roth Rules

The Roth IRA is a fabulous savings tool for your grandkids. A Roth can literally turn a few hundred dollars a year now, into tens of thousands of tax-free dollars for your grandkids when they retire by using the powerful combination of time and compounding.

But in order for you to open and fund a Roth IRA for a grandchild, one primary requirement will need to be met. The child will need to have earned income from some type of work – allowances don’t count. So, if your grandkid made a few bucks this year mowing lawns, babysitting, delivering newspapers or working an after-school or weekend job, he or she qualifies. Just be sure you keep good records including a log of the dates and hours worked and amounts paid, as well as any W-2 forms from employers or 1099s.

If your grandkids meet the earned income requirement, there’s nothing in the rules that says the child’s own money has to go into the Roth. It’s perfectly legal if your grandkids keep the money they earned and you make the contributions for them. The key is that you can’t contribute more than your grandchild earned in any given tax year, up to the limit of $5,000.

And to give you an idea of how these early contributions can add up, consider this. Let’s say, for example, that you contribute $500 a year to your grandchild’s Roth for nine years from the ages of 10 to 18 (a total of $4,500). If that money grew an annual rate of 7 percent, that $4,500 would accumulate to around $144,000 by the time he or she reaches age 65. And with a Roth IRA, the full amount will be tax-free when it’s withdrawn in retirement.

It’s also doubtful that your grandkids would be on the hook for income taxes. Children who work as employees generally don’t need to file a tax return unless their income exceeds the standard deduction amount, which was $5,700 for the 2010 tax year. They should, however, file if they’re due a refund for any withholdings. But a child who has net earnings of $400 or more from self-employment is required to file. For information on IRS filing requirements for children, visit www.irs.gov and search for the page titled “Taxable Income for Students.”

Flexibility

You also need to know that opening a Roth for your grandkids doesn’t automatically lock up the money for decades. Like it or not, your grandkids, at age 18, can withdraw the principle contributions (but not earnings) any time, tax free and penalty free.

Roth IRAs also offer special withdrawal rules for higher education expenses. So if your grandkid needs money for college, contributions can be withdrawn tax and penalty free, while the earnings can also be dipped into without penalty, but they will owe taxes on it. And when it comes time to buy a first home, your grandson or granddaughter can withdraw up to $10,000 (contributions and earnings) tax and penalty free.

Savvy Tip: For more information on Roth IRAs, see IRS Publication 590 at www.irs.gov/pub/irs-pdf/p590.pdf, or call 800-829-3676 and ask them to mail you a free copy.

Send your senior questions to: Savvy Senior, P.O. Box 5443, Norman, OK 73070, or visit SavvySenior.org. Jim Miller is a contributor to the NBC Today show and author of “The Savvy Senior” book.