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How a Child IRA Can Set Your Kid Up For Success

By Alice Ly
Updated on March 18, 2021
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Kids don’t have to be limited to their piggy banks. Here’s a long-term investment they can start making now.

As a parent, you obviously want the best for your kid(s) no matter their age. Maybe you’ve set up a children’s savings account or college savings plans to nurture that mindset. Maybe you wish to jumpstart your children’s retirement early on to take advantage of the gift of time. Or maybe you aren’t sure where to start.

While you may already be familiar with a Roth IRA as a common investment tool for adults, have you ever considered opening one for your kid?

As a refresher, a Roth IRA is a tax-free individual retirement account that allows you to save for retirement using special tax benefits. According to a 2019 report, 19.4% of U.S. households have a Roth IRA, and 28.1% have a traditional IRA.

A child IRA, however, could be the key to setting up your young loved ones for future financial success. Here’s everything you should know about leveraging this financial tool.

How child IRAs work

Despite the name, child IRAs don’t have any age limits, so your child can contribute to a Roth IRA at any age. 

The catch is that your child must show earned income in order to be able to contribute to a Roth IRA, according to financial services company Fidelity. The IRS defines earned income as taxable income and wages. In a child’s case, that type of wage could come from babysitting, dog walking, yard work, retail store work, or other side jobs that children and teens often participate in. 

Since some of these jobs typically don’t garner a W-2 or 1099 form, be sure to keep all records and receipts of the type of work, dates, the recipient of service, and how much your child earned.

If your child does have those types of forms, great! Same as adults, W-2 or 1099 forms officially keep track of work.

Another thing to note is that allowances will not count as income, nor will birthday money from relatives. However, if you have a business, you can offer your child an age-appropriate job for justifiable wages. Examples include having them appear in marketing promotions, keeping track of inventory, helping with customers, etc.

As the parent, you can also contribute to your child’s Roth IRA or match your child’s contributions, as long as your contributions don’t exceed your child’s total earned income. The IRS currently limits Roth IRA contributions to $6,000 in 2020. 

So, for example, if your daughter earns a total of $2,000 in 2020 by babysitting, she can contribute $2,000 into her Roth IRA, and you can contribute an additional $2,000 to match.

Note that there are also tax rules for monetary gifts. For 2020, the limit on tax-free gifts you can make to an individual is $15,000. Any contributions you make towards your child’s Roth IRA will count against that.

The benefits of your child having an IRA

Even though Roth IRAs aren’t normally associated with kids, they’re excellent saving tools. 

Unlike adults, who typically wait until their 30s or even 40s to begin saving, children still have decades to go before they hit retirement. This gives 50 or 60 years of time for their contributions to grow tax-free. 

Think of this example: A one-time contribution of $6,000 into a Roth IRA, with no additional contributions at all, would grow to almost $200,000 in 60 years with a 6% compound interest rate. What a great gift to your child knowing that their path to a secure retirement got a jumpstart early on. 

Plus, since contributions to a Roth IRA can be withdrawn tax- and penalty-free for qualified exceptions, there’s no worry if your child needs to use some of the money for an important purpose down the road like buying a first home, covering higher-education expenses, medical, birth or adoption expenses. This is far more flexible than other retirement accounts that charge a 10% penalty when money is withdrawn before the age of 59 ½. 

Establishing a Roth IRA for your child also provides an early valuable lesson in investing. The type of growth your child can accomplish through a Roth IRA simply can’t be done in a standard savings account. Even at a 1% interest rate, which is generous by the standards of most savings accounts nowadays, a contribution of $6,000 won’t even double after 60 years if it’s sitting in a savings account — even if it’s considered a high-yield account. (It would just total $10,900).

Opening a child IRA

A child IRA is no different than a standard Roth IRA in terms of its functionality. The only difference is that a child IRA requires a custodial or guardian account if your child is under the age of 18. As the custodian, you control the assets in the IRA and make all investment decisions until your child turns 18. 

When you open the IRA, it is created in your child’s name with their Social Security number, but you will be listed as the custodian of the account for the time being.

Not all banks or brokerages offer a custodial IRA, so first check with your own bank to see what options are available.

Finally, good luck, parents! By utilizing the gift of time for your kids, you can help set them up for a more comfortable retirement and foster healthy financial habits. You’ll just have to convince them to contribute the money into the account for something that happens decades from now rather than receiving instant gratification!

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