Retirement Savings Plans for Kids
Most of us will agree that the earlier you start to save for retirement, the easier it is to reach your financial target, and the less burdensome it is to save the required amount each period. It would stand true then, that if we start saving during childhood, it should make things even easier. What's more, an individual who starts saving as a child is more likely to develop good saving habits and is more likely to save consistently during his or her adult years.
We'll show you how to teach your child to start saving for the future in a way that is interesting and healthy. (Not in this age bracket? See Retirement Savings Tips for Young People, Retirement Savings Tips for 25- to 34-Year-Olds, Retirement Savings Tips for 35- to 44-Year-Olds or 6 Retirement Savings Tips for 45- to 54-Year-Olds.)
The eligibility requirements at the federal level are the same for minors and adults. For instance, the child must have eligible compensation in order for an individual retirement account (IRA) contribution to be made on the child's behalf. Additionally, the contribution is limited to the lesser of (a) 100% of compensation or (b) $5,500 plus inflation adjustments in future years.
For employer-sponsored plans such as SEP IRAs, SIMPLE IRAs and qualified plans, the eligibility of a minor who is employed by the company that sponsors the retirement plan would be determined by the plan's established eligibility requirements. For instance, if the employer requires employees to reach the age of 21 before being eligible to participate in the plan, any employee under the age of 21 will be excluded. (To learn more, see IRA Contributions: Eligibility and Deadlines and Tips on How to Use IRAs to Boost Retirement Savings.)
Sources of Income
In many cases, determining what is eligible compensation for funding an IRA is pretty simple. A child who earns compensation from a newspaper route, modeling, or as an office assistant or lifeguard, for instance, satisfies the 'eligible compensation' requirement.
The challenge comes in when the child works for a parent or other family member. A parent may need to demonstrate proof that amounts paid to a child are actually compensation for services performed if such services are for non-traditional employment. Pocket money given to a child, whether regularly or as a means of rewarding a child who completes chores, usually isn't considered eligible compensation for funding an IRA. For amounts not clearly defined by the IRS or the tax code as compensation for funding an IRA, a tax professional should be consulted for assistance in making the proper determination.
Establishing the Retirement Account
There is no minimum age at which a retirement account may be established for an individual. However, state law may prevent an individual from establishing a retirement account on his or her own until that individual reaches the age of majority, which ranges from age 18 to 21 depending on the state. In instances where the individual has not reached the age of majority, financial institutions will generally allow the individual's parent or legal guardian to establish a guardian IRA for a minor. In such cases, the paperwork is completed with the minor's name, Social Security number and other personal data, but is signed by the parent or legal guardian.
In addition to signing the paperwork used to establish the retirement plan, the parent or legal guardian is also required to sign any request for withdrawals.
Note: Not all financial institutions allow individuals to establish retirement account for minors. Check with your financial institution to determine availability.
The Benefits of Starting Early
Encouraging your child to start early will not only encourage good savings habits, but will put the child in a position to reach an established savings goal at an earlier age, and lower the amounts needed to be contributed to the plan each savings period. (To read more about age-related savings, read The Generation Gap, Delay in Retirement Savings Costs More in the Long RunIs it easier to save for retirement if you start earlier in life?)
Let's use an example to illustrate this point. Assume John wants to have $1 million saved by age 55. The amount John will need to save on a monthly basis in order to reach that goal is based on the age at which John starts saving. Let's look at Figure 1 and Figure 2:
As you can see in Figure 1, if John starts saving at age 15 at a rate of return of 5% and has no money saved when he starts, he will need to save $665.30 each month, in order to reach his goal.
Figure 2 shows what would occur if John starts saving at age 25 and starts with a zero balance. In this case, he will need to save $1,201.55 per month at 5% to reach his goal. (To find out how long it will take you to become a millionaire, check out our Millionaire Calculator.)
Learning to Invest Can Be Fun
The individual responsible for directing investments for a minor should exercise prudence. While it is an established philosophy that the younger the investor, the more risk one can take on with asset allocation, taking too much risk could disillusion a child if large amounts are lost due to bad investments. (To read more, see Portfolio Management for the Under-30 Crowd and The Seasons of an Investor's Life.)
When appropriate, the investment concept and strategy should be explained to the child. Using an investment simulator will help a child see for him- or herself the theories of market performance and risk that you are trying to teach. Most important, an investment planning advisor should be consulted for assistance in making the proper determination. (To try your hand at investing, check out our Investopedia Stock Simulator or the NASD's calculators for kids.)
The Bottom Line
Encouraging your children to save is one way of helping to ensure they will have a financially secure retirement. To ensure that a child develops good savings habits, parents can help their children understand basic investment concepts and the reason for saving. Involving your children in related discussions with financial planners and financial choices – assuming it is age appropriate – will help them to understand the big picture as they see their money grow.
“A good rule of thumb is to keep the process of learning both simple and visual,” says Mark Hebner, founder and president, Index Fund Advisors, Inc., Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.” “As an example, one of our Pinterest boards – Kids and Money – includes a pin showing that if a child fills a 2-liter bottle with dimes, $700 will be saved. Educating children that they, too, can potentially be a millionaire through a prudent investment policy is a powerful motivator.”