Young people often 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 a tax-free account like an IRA. Your child, regardless of age, can contribute to an IRA provided he or she has 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."
Here, we 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.
Types of IRAs for Kids
There are two different types of IRAs that 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 from now, he or she 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, he may be required to file an income tax return of his own if his gross income exceeds a certain amount set by the IRS ($12,000 for the tax year 2018). If your child earns less than this amount, he is likely in a 0% income tax bracket and she 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 and who, therefore, would not benefit from a deductible, traditional IRA.
“If a child keeps [a Roth] until age 59½ (under today's rules), any withdrawal will be tax-free. In retirement, he or she would likely be in a much higher bracket, so would effectively be keeping more of his or her money,” says Allan Katz, president, Comprehensive Wealth Management Group, LLC, in Staten Island, N.Y. 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 out 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.
Banks, brokers, and mutual funds 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 custodial IRA until your child reaches majority age, at which point the assets are turned over to him or her.
The IRA is opened in your child’s name, and you will have to provide her Social Security number when you open the account.
Keep in mind, not all firms allow minors to have IRAs. Firms that currently open accounts for minors include:
Investopedia has created a list of the best brokers for IRAs, where you can compare the best brokers side-by-side.
How to Contribute to 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 his own. For 2019, the maximum your child can contribute to an IRA (either traditional or Roth) is the lesser of $6,000 or his or her taxable earnings for the year. For example, if your son earns $3,000 this year, he could contribute up to $3,000 to an IRA; if your daughter earns $10,000, she could contribute only $6,000, the maximum contribution. If your child has no earnings, he or she 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, therefore, 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:
- Type of work
- When the work was done
- For whom the work was done
- How much your child was paid
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 probably won’t get away with paying your daughter $150 an hour to wash dishes, for example). It helps if the child does similar work for outsiders – doesn't just mow the family's lawn, but others in the neighborhood, for example. Or if you have your own business, you can put your child to work doing age-appropriate tasks for reasonable pay.
Many parents choose to “match” their child’s earnings and make the IRA contribution themselves. For example, if your daughter earns $3,000 at a summer job, you can let her spend her money as she wishes 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).
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 Joe Jr. made $2,000 from his lemonade stand one summer, $2,000 is all you or he 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
Opening an IRA for your child provides him or her not only a head start on saving for retirement, but also valuable financial lessons. Even a small IRA can provide a platform to teach your child about taxes, retirement, compounding and the relationship between earning, saving and spending.
“Any time you work one-on-one with your child to teach them about money, investing and saving is time well spent. Compounding works best if it has the most amount of time to work its magic. If you are able to start your child early, it will give them a head start on their financial future,” says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
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 double the contribution to $100 each month and the account could reach $262,685.
Another benefit of IRAs is that your child may be able to tap into the account for qualified higher education expenses and up to $10,000 towards a down payment on a first home without penalty. With a Roth IRA, you can withdraw any contributions, for any reason without tax or penalty, and you can withdraw earnings in special circumstances.
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, CFP®, principal, Harbor Financial Group, Inc., Boulder, Colo. “The establishment of the Roth IRA is a great opportunity to talk about compounding, the importance of saving for the future and an introduction to investing.”
The Bottom Line
Young people have a tremendous advantage in time. Even relatively small IRA contributions can grow significantly over time due to the power of compounding. In addition to the cold hard cash building 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 started early can make a big difference in financial security later on.
“Starting an IRA for your child can be a wonderful thing. At their young age, compounding kicks into high gear due to the long time horizon. And usually they will be in a low, or even zero tax bracket so the Roth is normally the best choice,” says Dan Stewart, CFA®, president and CIO, Revere Asset Management, Inc., in Dallas, Texas.