As a parent, I want only the best for my children. It is why we tell them to brush their teeth, give them chores, and sign them up for character-building extracurricular activities.
When it comes to money, parents also want their kids to walk on the right path. We might talk about the significance of saving up for major purchases or for college. We may offer them allowances to help them learn to manage money on their own or play games with them such as Monopoly to introduce them to the world of finance. But parents often fall short when it comes to aiding their children to understand the more complex topic of building wealth for the long-term through investing. It is extremely important to have a conversation or two about saving for retirement, especially by the time your child has a part-time summer or high school job. A traditional or Roth Individual Retirement Account (IRA) can be a great tool to help them see the impact of saving and investing for retirement, and with IRAs of their own, children can personally see how these retirement accounts work.
How do I open an IRA for a child?
The difference between a traditional and a Roth IRA for a child is the same as the difference between those two tax-advantaged retirement accounts for an adult. Traditional IRAs allow the account owners to make deposits up to a certain amount and then count that amount toward a tax deduction. Any withdrawals taken from a traditional IRA are subject to taxes.
For Roth IRAs, the tax advantage comes later. When you make these deposits, the funds are already taxed as income. Then, when you withdraw those funds, you will not have to pay taxes on any gains your investments have made. Many youths, such as those who hold part-time or summer-only jobs, have annual incomes that fall below the taxable threshold. In these cases, contributions to a Roth IRA and distributions have the potential to be tax-free.
To open a traditional or Roth IRA for minors, you will need to open it in your child’s name and manage the account as a custodian. Then, when your child reaches the age of majority in your state, whether it be 18 or 21, your child takes over the management of the IRA. If you already have an investment account, check to see if your broker offers a traditional or Roth IRA for kids. Chances are they do. Because the account is in your child’s name, all you should need is his or her social security number.
Traditional & Roth IRA for kids: It is never too early
There is no age restriction on a traditional or Roth IRA for kids. If your five-year-old child has earned income (unlikely but possible), you could conceivably open an IRA in his or her name and start the retirement saving process. The earlier children start investing, the more time their investments must flourish.
As with any IRA, an IRA for a minor comes with contribution caps. For 2021 you can contribute $6,000 per year, but you will not be able to put that much into an IRA for your child if he or she does not earn above that threshold. If your child makes $3,000 as a waiter or waitress over the summer and does not make any other money during the year, that is the limit. Earned income, for the purposes of a traditional or Roth IRA for kids, includes money from any job they would report on a tax return. Self-employment, like mowing lawns and babysitting, counts as earned income. Your child can also work doing small tasks for your family business if you pay them a reasonable wage. You and your child can both make contributions, but your joint annual contributions cannot exceed either the child’s total earned income or $6,000, whichever is lower.
One incentive is to introduce a match. Promise your children that if they invest with money from their jobs, you will match it with your own money. This should encourage them to take an interest in their financial future.
What are some investment lessons with a traditional or Roth IRA for a child?
A traditional or Roth IRA for minors can be one way to help your child pursue long-term wealth by offering a number of savings and investment lessons. As you and your child contribute to the account, make sure to share and discuss the fund’s performance.
As your child’s portfolio develops, you can help identify where successful and unsuccessful investment choices were made. You can take the opportunity to discuss why a particular stock increased or decreased, and what lessons an investor can learn in hindsight from how your child’s portfolio performed.
Watching the account over time and engaging in discussions about it can help your child remain excited about retirement investing. Kids who catch the “investing bug” at an early age may be more likely to continue contributing once they’re managing their retirement portfolio on their own.