It’s never too early to start saving for retirement — including during childhood. You can help your child take full advantage of the power of long-term compounding by helping him or her open an IRA.
Take Advantage of Compounding
Time is the greatest ally when it comes to long-term financial goals like saving for retirement. By opening and contributing to an IRA, your children could potentially benefit from a half-century or longer of tax-advantaged compounding in their efforts to save money for a financially secure retirement.
The only requirement for opening an IRA for your child is that he or she must have earned income. The IRS defines earned income as “all the taxable income and wages you get from working for someone who pays you or in a business you own.”
So your child’s income must be earned by working for an employer — money earned as an allowance generally doesn’t count. If you own a business, you can hire your child to work for you by performing age-appropriate tasks. Money your child earns by mowing yards in the neighborhood, babysitting or walking the neighbors’ dogs also counts.
Your child will ideally receive a W-2 or 1099 form substantiating these wages, but this isn’t technically required and probably wouldn’t happen for jobs like these. Therefore, it’s usually smart to maintain some kind of written record of the work your child did to earn the income, including the type of work done, who it was done for, the date the work was performed and how much was paid for the work.
Opening an IRA for Your Kid
Opening an IRA for a child isn’t any different from opening one for an adult. The account will be opened in your child’s name, using his or her Social Security number. The biggest difference is that a child’s IRA must have an adult as the custodian or guardian of the account.
The custodian will control the assets and make investment decisions until the child reaches the age of majority (18 or 21, depending on the state), at which time the child will assume control of the account. Of course, you can talk to your child about how you make investment decisions and involve him or her in these decisions.
Others can make contributions to your child’s IRA if they wish. For example, you or your child’s grandparents might match your child’s savings to encourage him or her to contribute more. The only stipulation is that total contributions can’t exceed the income earned by the child during the year. Total contributions are subject to the same annual limits as any other IRA ($6,000 in 2021).
Roth or Traditional IRA?
You can open either a Roth or a traditional IRA for your child. But given your child’s likely low tax bracket now, a Roth IRA is generally considered the best option for children. Traditional IRAs offer a tax deduction for contributions, but this is probably of little benefit to a child in a low (or zero) tax bracket.
Another advantage of Roth IRAs for children is that funds are withdrawn tax-free in retirement, when the child will likely be in a higher tax bracket than now. In addition, Roth IRA principal (but not earnings) can be withdrawn at any age without penalty. This could give your child more flexibility in how he or she uses the funds — for example, withdrawals could be used to make a down payment on a first home, pay for college education expenses or cover an unexpected financial emergency.
Of course, any funds withdrawn for purposes other than retirement could jeopardize a child’s retirement income security. So it’s generally better to leave IRA funds in the account until retirement instead of withdrawing them early for non-retirement purposes.
A Financial Education
Opening an IRA for your child will not only give him or her a head start in saving for retirement, but it will also help your child start learning important financial lessons at an early age. One of these is the importance of saving regularly to meet long-term financial goals like retirement. Another is the power of compounding returns, in which money is earned not only on the funds invested but also on money that the investments earn.
In other words, compounding is earnings on top of earnings. Here’s an easy way to explain it to children: If a $1,000 investment earns 10% a year, it will be worth $1,100 after one year. In year two, earnings would be computed on $1,100, not $1,000 — so if it earned 10% again, it would earn $110 and be worth $1,210. When this occurs year after year for decades, it can multiply the value of an IRA exponentially.