Most children aren’t worried about their retirement years. But you can never start too early when it comes to retirement, financial advisors say. Retirement accounts like an IRA for kids actually exist – and they can be valuable financial tools.
Believe it or not, even children of any age can start saving for retirement account with tax advantages.
The benefits of saving early are tremendous. Just think: a $1,000 investment at age 15 with a 7% annual gain (and no other contributions) would be worth around $57,000 by age 75.
Imagine if your child continued to save regularly through their young and adult life. They could easily enjoy a financially secure retirement.
In this article, we’ll cover:
- What does an IRA do?
- Can I open an IRA for my child?
- What are benefits of a custodial IRA?
- When can you start an IRA for a child?
- What is the difference between a traditional and Roth IRA for Kids?
- How much can a child contribute to a Roth IRA?
- Can parents contribute to a Roth IRA for a child?
- Does a child Roth IRA affect financial aid?
- Using a Roth IRA for children’s education
What does an IRA for Kids do?
An IRA, or an Individual Retirement Account, allows you to save money for retirement with the benefit of tax breaks.
Depending on the type of IRA you have – either traditional or Roth (which we’ll discuss below) – you get a different tax break. You can get your income taxed reduced as you file annual taxes. Or, you can delay your tax break until you withdraw your funds to use during retirement.
With an IRA, you can make regular contributions or one lump sum – it is up to you how you contribute. But keep in mind that there are limits to how much you can put in an IRA each year.
For 2020, you can deposit up to $6,000, up from $5,500 in 2019. If you’re over age 50, you can deposit an additional $1,000 for a total of $7,000. And you actually have longer than the calendar year to make an IRA contribution – you can deposit up until tax-filing day.
To get the most out of an IRA for kids or adults, you should try to contribute up to the maximum each year. Of course, children and adults are going to have very different financial priorities.
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Can I open an IRA for my child?
Yes, you can open an IRA for your child of any age. If your child is earning income, you can open an IRA for them, no matter what their age. The IRA for a child will be considered a “custodial” IRA because an adult must serve as the custodian.
So, a child cannot open an IRA themselves. A parent or guardian needs to do it for them. Then, when the child turns 18 (or 21 in some states), the child will own and manage the account.
To open an account, you’ll usually need to provide some key personal information about the child and custodian:
- Social Security number
- Date of birth
- A driver’s license number (If they have one)
- Employment Information
What are benefits of a custodial IRA for kids?
A traditional or Roth IRA for children has all the same benefits that IRAs provide to adults as far as helping build retirement funds. The main benefit to IRAs for kids is that they give children a jump-start on retirement savings with the major advantage of tax savings.
The earlier you start to save and invest, the faster and more effectively your money can compound, or grow with a snowball-like effect.
While the main purpose of an IRA is to save for retirement, your child may be able to use the funds in an IRA for kids for other expenses like paying for a down payment on their house or paying for their college tuition. Many times, making a withdrawal for college tuition does not carry a penalty.
Often, you can make trades within a custodial IRA for a child with no commission fees.
When can you start an IRA for a child?
You can start an IRA for a child at any age. The only requirement is that they are earning money, whether it’s though babysitting or selling lemonade. Even a little baby with a modeling gig can contribute to their own IRA.
Not all banks offer an IRA for kids, but many firms do. Among them are Charles Schwab, Vanguard and Fidelity. As a custodian, you will receive the statements for the account.
What is the difference between a traditional and Roth IRA for Kids?
The difference between traditional and Roth IRAs is the way they are taxed. Traditional IRAs bring tax advantages immediately through an income tax reduction. The benefit of Roth IRAs is delayed until you retire and withdraw those funds, will then be considered tax-free income.
Basically, with traditional IRAs for kids, you write off whatever amount to contributed to the IRA as a tax deduction.
So, the total taxes you owe that year are reduced. However, when you go to withdraw those funds during retirement, you must pay taxes (although usually at a lower rate because many retirees move to a lower income bracket.) You must also pay taxes on any gains you made on your investments.
With Roth IRAs for kids, you make contributions to your IRA through the year. But you don’t deduct the contributions from you taxable income. Instead, when you retire, you can make withdrawals tax-free, and that includes on any gains.
One thing that’s different for children is the fact that they usually earn a lot less. So, in many cases, what they earn won’t be subject to an income tax because it’s so little.
In those cases, it makes the most sense to put that money in a Roth IRA for kids. That way, you get both the advantage of paying no income tax now, and paying no income tax when you make withdrawals.
How much can a child contribute to a Roth IRA?
Like with any IRA, there are caps on how much a child can contribute to their traditional or Roth IRA.
There’s no minimum requirement – so technically you could open an IRA account with $0. (Some financial institutions may have a minimum investment requirement. The IRS does not.) As of 2020, the maximum contribution limit is $6,000.
You cannot contribute more than the child earns in a particular year. So, for example, if your child earned $1,200 in babysitting or mowing lawns, they could not contribute more than that to their IRA.
If you go over the maximum contribution limit, you may face a penalty. However, most IRA accounts are diligent about giving you notices to help you avoid going over the maximum.
Can parents contribute to a Roth IRA for a child?
Yes, guardians and parents can contribute to a Roth IRA for a child. Oftentimes, a child or teen might want to keep their funds instead of putting them toward retirement. After all, Retirement seems very far away to them and their money for what they want now is limited.
IN that case, a custodian may contribute on behalf of the child, but only up to the amount the child has earned or the
The custodian who is in control of the child’s IRA account makes decisions on contributions, how to invest and on any distributions.
Once the child reaches age 18 or 21, depending on the state, they may request to have the funds transferred to a new account in their name only. Then, they alone will be able to make decisions about when and how much to contribute to their IRA.
Does a child Roth IRA affect financial aid?
The money you contribute to a child’s IRA does not factor into financial aid calculations. The FAFSA (Free Application for Student Aid) application process does not ask about money in retirement accounts. So, not matter how much is in your child’s IRA account, it will have no impact on the amount of financial assistance your child can get for their education.
Also, you can usually withdraw funds from a Roth IRA for kids to pay for college tuition and face no fees or taxes. However, while you can avoid taxes on withdrawing the amount you contributed, you may still have to pay taxes on any gains the investments have made.
Finally, be aware that any withdrawals from an IRA for college funding could be counted as income. In that case it would have a role in financial aid considerations.
So, you should delay withdrawing money to pay for college expenses until after your FAFSA, or financial aid, forms are processed.
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Using a Roth IRA for Children’s Education
Parents have many opportunities to guide their children in the right direction with their money. A traditional or Roth IRA for kids is an excellent chance to show them how investing works – how their money can grow over the long-term.
You can teach them about the pros and cons of different investments types that they make within their IRA. They can learn, for example, why one stock declined while another made gains. And they can see how modest savings can grow substantially over time with wise investments.
Aside from lessons in investing, an IRA can shed some light on how to manage money and the benefits of saving instead of spending. It can open the door to discussions on a number of financial topics – from saving for major purchases to creating a budget.
To supplement these lessons, parents can also provide allowances when their child is not earning income. Or pay them for doing chores. They may even want to buy games related to money to give kids a sense of how cash flows.
The Bottom Line
A traditional or Roth IRA for kids can be an excellent way for them to get a head start on saving money for retirement. Having a retirement account at a young age can also bring valuable lessons in investing, saving and budgeting.
If your child is earning money, you may want to consider opening an IRA account for them to receive when they are older. There are many benefits, and very few downsides to opening an IRA for kids early.