Individual retirement accounts (IRAs) are an excellent investment option for people who are looking to save up for retirement.
Contrary to what some people think, IRAs are not just meant for adults with full-time jobs. Anyone who is younger than the age of 70½ (which includes children) and is earning an income can contribute to an IRA.
By investing in IRAs at a young age, children can take full advantage of the power of compounding and reap the rewards in their retirement years.
In this guide, we take a look at the differences between the two types of IRAs available for children and discuss why it is important for your child to contribute to an IRA right from a young age.
The two types of IRAs for children
Parents who are looking to open an IRA for their children generally have two options — traditional and Roth. While both IRAs allow your child to save up for retirement, they differ from each other in two key ways.
With a traditional IRA, the contributions you make are tax-deductible. You will be, however, taxed when you start withdrawing money from the account during your retirement years.
With a Roth IRA, the contributions you make are taxed at standard income tax rates. You will not be, however, taxed when you start withdrawing money from your account.
In other words, with a Roth account, you pay taxes when you invest your money. With a traditional account, you pay taxes when you withdraw your money.
With a traditional IRA, you have to start withdrawing money on a regular basis from the age of 70½. If you fail to do so, you will have to pay a penalty.
A Roth IRA, on the other hand, does not have any such rules for withdrawals. While you are allowed to withdraw money from your account once you reach the age of 59½, there are no penalties for not making a withdrawal.
You can let the money in your account grow on a tax-free basis for as long as you want.
Which one is the better choice for your children?
Generally speaking, a Roth IRA is better suited for your children than a traditional IRA for three reasons.
- Your child is not likely to earn enough money to take full advantage of the tax incentive offered by a traditional IRA.
- The contributions to a Roth IRA are taxed, but the withdrawals are not. Since your child is unlikely to be in a lower tax bracket than he or she is right now, it actually works to their advantage.
- Unlike a traditional IRA, a Roth IRA does not have mandatory required minimum distributions (RMDs). You can choose to make tax-free withdrawals from the age of 59½ or let the money grow for as long as you want.
So, a Roth IRA is certainly a better choice for your child, irrespective of his or her age.
How to set up a Roth IRA for your child
There are several banks, mutual funds, and brokers which offer custodial or guardian accounts for minor children.
You have to provide your child’s name, birth date, and Social Security number in order to open an account in his or her name.
As the guardian or custodian of the child, you get to make the decisions regarding investments and withdrawals.
When your child reaches the age of 18 or 21 (depending on the state you live in), the money in the account (principal contributions as well as the accrued interest) is transferred to a new account, which your son or daughter can manage on their own.
Contributing to your child’s IRA
The maximum amount of money that can be contributed to a Roth IRA account as of 2019 is $6,000 per year. The only stipulation is that the money your child invests should be “earned income,” money paid in exchange for work.
Your child is usually required to fill out a W-2 or Form 1099 for the work he or she performs. It is, however, not the case with entrepreneurial gigs like dog walking or babysitting, since your child is likely to be paid in cash.
So, you need to make sure your child’s income is properly documented with receipts and other records.
In some cases, children might be reluctant to invest all of their hard-earned money in a retirement account. If your child feels the same way, you can allow him or her to spend a portion of their earnings and you can contribute the same amount of money from your pocket.
For instance, if your girl has earned $1,500 and wants $500 for herself, you can allow her to spend it on whatever she likes, contribute $500 from your own pocket, and invest $1,500 into your child’s account.
As long as your contributions do not exceed the total amount of money your child has earned there should not be a problem.
Benefits of opening an IRA for your children
The biggest advantage of opening an IRA for your children is that it gives them a headstart on retirement planning. It’s a salient way to instill a sense of financial responsibility in your child at a young age.
Most importantly, an IRA allows your child to take full advantage of the power of compounding.
If your child invests $5,000 just one time in a Roth IRA at the age of 15, he will have $105,000 in his account when he turns 60 (assuming a 7% interest rate compounded annually).
The important thing to be noted here is that the $5,000 grows into $105,000 in 45 years even if your child does not make a single additional contribution, which is the power of compounding.
Now, think of the kind of retirement corpus your child can build if he or she chooses to make regular contributions to their IRA right from a young age. By the time they enter retirement they could be financially independent!
Starting an IRA for your child
Opening an IRA for your children is one of the best decisions you can make regarding their financial future. Starting an account today lets your child make the most of the two factors which play a key role in wealth creation — time and compound interest.