Some young people will open individual retirement accounts (IRAs) when they start receiving paychecks from their first job. But actually, IRAs make excellent savings vehicles for people of an even younger age. Because of their tender years, and the decades they have before them, children are poised to take full advantage of time and the power of compounding within this type of tax-advantaged savings vehicle.
Your child, regardless of age, can contribute to an IRA provided they have earned income, defined by the IRS as “all the taxable income and wages you get from working…for someone who pays you or in a business you own.”
Below, we’ll take a look at two types of IRAs for children, the benefits these tax-advantaged investment vehicles offer, and how to open and make contributions to an IRA for kids.
Key Takeaways
- An IRA can help your child (or grandchild) save for retirement, a first home, or educational expenses.
- While both traditional and Roth IRAs are options, the Roth variety often is preferable, as it favors those who’ll be in a higher tax bracket later in life.
- Any child, regardless of age, can contribute to an IRA provided they have earned income; others can contribute too, as long as they don’t exceed the amount of the child’s earned income.
- A child’s IRA has to be set up as a custodial account by a parent or other adult.
Types of IRAs for Kids
Two different types of IRAs are suitable for children: traditional and Roth. The primary difference between traditional and Roth IRAs is when you pay taxes on the money that you contribute to the plan. With a traditional IRA, you pay taxes when you withdraw the money during retirement (at your then-applicable tax rate). All the funds, both your contributions and any earnings they’ve accrued, are considered pre-tax in a traditional IRA.
With a Roth IRA, you pay taxes when you put the money into the account, so the funds—the contributions and their earnings—are considered after-tax money.
The money grows tax-free while it’s in either a traditional or Roth IRA. But the benefit of a Roth is that when the child withdraws the money many decades later, they won’t have to pay income tax on it. What’s more, there are no required minimum distributions (RMDs) on the money. Of course, these rules may change in the next 40 years, but that’s where they are now.
Even if you claim your child as a dependent, they may be required to file an income tax return of their own if their gross income exceeds a certain amount set by the IRS. If your child earns less than this amount, they are likely to be in a 0% income tax bracket, and they probably won’t benefit from the up-front tax deduction associated with traditional IRAs.
Advantages of Roth IRAs for Kids
Because many kids don’t earn enough money to benefit from the up-front tax deduction associated with traditional IRAs, it makes sense in most cases to focus on Roth IRAs. In general, the Roth IRA is the IRA of choice for minors who have limited income now—as it’s recommended for those likely to be in a higher tax bracket in the future.
“If a child keeps [a Roth] until age 59½ (under today’s rules), any withdrawal will be tax-free. In retirement, they would likely be in a much higher bracket, so would effectively be keeping more of their money,” says Allan Katz, president of the Comprehensive Wealth Management Group in Staten Island, New York.
Even if a child wanted to use the funds earlier than that, the account would be advantageous: Roth IRAs are tailor-made for people whose tax bracket is likely to be higher when they need to take the money out, as opposed to when they’re putting it in.
How to Open an IRA for a Child
Although you may see brokers trumpeting “A Roth IRA for Kids” (as Fidelity Investments does) or some such, there’s nothing special in the way a child’s IRA works, at least as far as the IRS is concerned. The opening amount to invest may be less than the brokerage’s usual minimum. Otherwise, the main difference between these IRAs and regular ones is that they are custodial or guardian accounts.
By law, banks, brokers, and investment companies require custodial or guardian accounts if your child is a minor (under age 18 in most states; under age 19 and 21 in others). As the custodian, you (the adult) control the assets in the IRA, making all investment decisions, until your child reaches majority age, at which point they are turned over to them.
The IRA is opened in your child’s name, and you will have to provide their Social Security number when you open the account.
Keep in mind, not all financial institutions do custodial IRAs. Firms that currently open accounts for minors include the following:
Investopedia has created a list of the best brokers for IRAs, where you can compare the best brokers side by side.
How to Fund a Child’s IRA
Children of any age can contribute to an IRA as long as they have earned income from a job, be it from an employer (like a paper route or lifeguarding) or from a little business of their own.
For 2021 and 2022, the maximum your child can contribute to an IRA (either traditional or Roth) is the lesser of $6,000 or their taxable earnings for the year. For example, if your youngest child earns $3,000 this year, they could contribute up to $3,000 to an IRA; if your oldest child earns $10,000, they could contribute only $6,000, the maximum contribution. If your child has no earnings, they cannot contribute at all.
The important thing to remember is that your child must have earned income during the year for which a contribution is made. Money from an allowance or investing income does not count as earned income and thus cannot be used towards contributions.
Ideally, your child will receive a W-2 or Form 1099 for work performed. But of course, that usually doesn’t happen with entrepreneurial endeavors like babysitting, yard work, dog-walking, and other common juvenile jobs. So it is a good idea to keep receipts or records. These should include the following:
- Type of work
- When the work was done
- For whom the work was done
- How much your child was paid
The money can’t be an allowance (even if the child does chores for it) or a cash gift given directly to the child. Still, although allowances are not allowed, you may be able to pay your child for work done around the house, provided it is legitimate and the pay is at the going market rate. (You can’t pay $1,000 for a night of babysitting, for example.)
It helps if the child does similar work for outsiders—doesn’t just mow the family’s lawn, for example, but the lawns of others in the neighborhood. Or, if you have your own business, you can put your child to work doing age-appropriate tasks for reasonable wages.
There are also some types of income that are not eligible for IRA contributions. The list includes:
- Rental income or other profits from property maintenance
- Interest income
- Pension or annuity income
- Stock dividends and capital gains
- Passive income earned from a partnership in which you do not provide substantial services
The IRS dictates not only how much money you can deposit in a Roth IRA but also the type of money that you can deposit. Basically, you can only contribute earned income to a Roth IRA.
For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses, and other amounts paid to the individual for the services that they perform. It’s generally any amount shown in Box 1 of the individual’s Form W-2. For a self-employed individual or a partner or member of a pass-through business, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.
Money related to divorce—alimony, child support, or in a settlement—can also be contributed if it is related to taxable alimony received from a divorce settlement executed prior to Dec. 31, 2018.
And, as previously mentioned, you receive no tax deduction for the contribution—although
you may be able to take a Saver’s Tax Credit
of 10%, 20%, or 50% of the deposit, depending on your income and life situation.
Can Others Contribute to a Child’s Roth IRA?
Yes. Direct contributions to a child’s Roth IRA can be a gift from you or someone else. And they truly are gifts that keep on giving. Since Roth IRAs can be invested in almost any sort of asset, they are likely to perform much better than a good old savings bond or bank account.
Many parents choose to “match” their child’s earnings and make the IRA contribution themselves. For example, if your child earns $3,000 at a summer job, you can let them spend their money as they wish and make the $3,000 IRA contribution with your own money. You might also offer to contribute a percentage of what your child earns, such as 50%. (Your child earns $3,000 and you contribute $1,500.)
Remember to consider gift tax rules. The contributions you make to a Roth IRA for your kid will count against the limit on tax-free gifts you can make to one person, which is $15,000 for 2021 (rising to $16,000 in 2022).
Whatever approach you decide to take, the IRS doesn’t care who makes the contribution as long as it does not exceed your child’s earned income for the year. If Sam made $2,000 from their lemonade stand one summer, $2,000 is all you or Sam can invest in the IRA. Since the contribution is made to your child’s IRA, your child—not you—receives any tax deduction.
Benefits of IRAs for Kids
Along with the obvious motivations—building a nest egg—IRAs offer other benefits for kids, both in the present and in the future.
Financial Literacy
Opening an IRA for your child provides them not only a head start on saving for retirement, but also valuable financial lessons. Even a small IRA can provide an introduction to investing and a platform to teach your child about money and the relationship between earning, saving, and spending. It can also teach them the lesson of compounding, which works best if it has the longest amount of time to work.
For example, a single $1,000 IRA contribution made at age 10, for example, could grow to $11,467 over 50 years, assuming a conservative 5% average annual growth rate. Contribute $50 each month, and the account might grow to $137,076 (with the initial $1,000 contribution and the same hypothetical growth rate of 5%). Or you can double the contribution to $100 each month, and the account could reach $262,685.
Tangible Uses
Another benefit of IRAs is that your child may be able to tap into them for other important expenses—particularly if they are Roths, which allow withdrawals of contributions, provided the account is at least five years old. Regular IRAs are tougher but allow penalty-free withdrawals in special circumstances. Such needs could include the following:
- Education expenses: The account-holder can withdraw money for college, but they will pay taxes on the earnings. However, there is no 10% early withdrawal penalty if the money is used for qualified education expenses (tuition, fees, books, supplies, equipment, and most room and board charges).
- Buying a house: The account-holder can withdraw funds to buy a house before reaching 59½. The money must be used as a down payment or for closing costs. The withdrawal is limited to $10,000. Early withdrawals for a home purchase are penalty-free and tax-free.
- For emergencies: The owner of a Roth IRA can withdraw money in an emergency. But the withdrawal will be subject to taxes on the earnings, plus a 10% early withdrawal fee.
However, “we suggest keeping these funds intact if at all possible rather than removing them for a first home purchase, for example,” says Elyse Foster, certified financial planner and principal of Harbor Wealth Management in Boulder, Colorado.
Can I Open an IRA Account for My Child?
Yes. Your child, regardless of age, can contribute to an IRA provided they have earned income, defined by the IRS as “all the taxable income and wages you get from working…for someone who pays you or in a business you own.”
How Much Can I Put in My Child’s IRA?
IRA contributions cannot exceed a minor’s earnings. For example, if a child earns $1,000 in a year, then only $1,000 can be contributed to the account. There’s also an annual maximum contribution of $6,000 per child, per year for 2021 and 2022.
How Does a Custodial IRA Work?
A custodial IRA is an individual retirement account that a custodian (typically a parent) holds for a minor with an earned income. Once the custodial IRA is open, all assets are managed by the custodian until the child reaches age 18 (or 21 in some states).
The Bottom Line
Young people have a tremendous advantage when it comes to investing—namely, time. “At their young age, compounding kicks into high gear due to the long-time horizon,” says Dan Stewart, a chartered financial analyst, president and CIO, Revere Asset Management in Dallas, Texas.
Stewart tends to favor Roth IRAs, since “usually they will be in a low or even zero tax bracket.” Even relatively small IRA contributions can grow significantly over time, he notes. If you make a single, one-time $6,000 contribution to a child’s Roth IRA when they are 15, for example, that can grow to more than $176,000 of tax-free money by the time they hit 65, assuming a 7% annual return. If they waited until they were 35 to make that first contribution, they would need to invest $23,000 to reach the same amount.
In addition to the cold hard cash growing in an IRA account, your child will have the added benefit of developing healthy financial habits: Many financial experts and educators believe that the earlier children begin learning about money, the better their chances for financial stability in the future.
It may be a hard sell to kids compared to spending money they’ve earned (or saving it for college, something that will happen way sooner than retirement)—but an IRA that’s opened early can spell a lot of financial security later on.
Source: finance.yahoo.com