The Benefits Of Starting An IRA For Your Child

While IRAs are well-known among adult investors, they also make excellent savings vehicles for children who, because of their age, are poised to take full advantage of time – and the power of compounding. Your child – regardless of age – can contribute to an IRA provided he or she has earned income from a job. Here, we take a look at two types of IRAs for kids, the benefits these tax-advantaged investment vehicles offer, and how to open and make contributions to an IRA for kids.

Types of IRAs for Kids

There are two different types of IRAs that are suitable for children: traditional and Roth. The primary difference between traditional and Roth IRAs is when you pay taxes on the money that you contribute to the plan. With a traditional IRA, you pay taxes when you withdraw the money during retirement (at your then-applicable tax rate). A traditional IRA contains pre-tax earnings. With a Roth IRA, you pay taxes when you put the money into the account, so it contains earnings after tax. The money grows tax free while it's in either a traditional or Roth IRA.

If you claim your child as a dependent, he may be required to file an income tax return of his own if his income exceeds a certain amount set by the IRS ($6,100 for 2013). If your child earns less than this amount, she is likely in a 0% income tax bracket and she probably won't benefit from the up-front tax deduction associated with traditional IRAs. Because of this, it makes sense in most cases to focus on Roth IRAs. With a Roth IRA, you get no deduction when you make contributions, but years later the money – both contributions and earnings – comes out tax-free. In general, the Roth IRA is the IRA of choice for minors who have limited income and who, therefore, would not benefit from a deductible traditional IRA.

Because many kids don't earn enough money to benefit from the up-front tax deduction associated with traditional IRAs, it makes sense in most cases to focus on Roth IRAs. With a Roth IRA, you get no d! eduction when you make contributions, but years later the money – both contributions and earnings – comes out tax-free. In general, the Roth IRA is the IRA of choice for minors who have limited income and who, therefore, would not benefit from a deductible traditional IRA.

Benefits of IRAs for Kids

Opening an IRA for your child provides him or her not only a head start on saving for retirement, but also valuable financial lessons. Even a small IRA (Schwab, for example, allows you to open a custodial account with just $100) can provide a platform to teach your child about taxes, retirement, compounding, and the relationship between earning, saving and spending.

While retirement income is likely to be the last thing on your young child's mind, most kids are intrigued with the idea that a small investment today can turn into a big chunk of change later. Young children may not understand the concepts behind interest, earnings and compounding, but they are old enough to appreciate the fact that their money can grow.

A single $1,000 IRA contribution made at age 10, for example, could grow to $11,467 over 50 years, assuming a conservative 5% average annual growth rate. Contribute $50 each month, and the account might grow to $137,076 (with the initial $1,000 contribution and the same hypothetical growth rate of 5%). Or double the contribution to $100 each month and the account could reach $262,685. As children make more money and eventually become adult earners, their annual contributions are likely to be higher, and the IRA could grow correspondingly. Setting aside money each month or year for an IRA – even if the contributions are small – helps your child develop awareness and healthy financial habits.

Another benefit of IRAs is that your child may be able to tap into the account for qualified higher education expenses and up to $10,000 towards a down payment on a first home without penalty. With a Roth IRA, you can withdraw any contributions, but not the investment earnings, for any reason without tax or penalty.

IRA Accounts

If your child is a minor (under age 18 in most states; under age 19 and 21 in others), many banks, brokers and mutual funds will let you set up a custodial or guardian IRA. As the custodian, you (the adult) control the assets in the custodial IRA until your child reaches age 18 (or 21 in some states), at which point the assets are turned over to him or her. The IRA is opened in your child's name, and you will have to provide his or her social security number when you open the account. Keep in mind, not all firms allow minors to have IRAs. Firms that currently open accounts for minors include:

Charles Schwab E*Trade Scottrade T. Rowe Price TD Ameritrade Vanguard Children of any age can contribute to an IRA as long as they have earned income from a job, be it babysitting, yard work or walking neighborhood dogs. For 2013, the maximum your child can contribute to an IRA (either traditional or Roth) is the lesser of $5,500 or his or her taxable earnings for the year. For example, if your son earns $3,000 this year, he could contribute up to $3,000 to an IRA; if your daughter earns $10,000, she could contribute only $5,500, the maximum contribution. If your child has no earnings, he or she cannot contribute at all.

The important thing to remember is that your child must have earned income during the year for which a contribution is made. Money from allowance or investing income does not count as earned income and, therefore, cannot be used towards contributions. Ideally, your child will receive a W-2 for work performed; otherwise, it is a good idea to keep excellent records from jobs that don't provide a W-2: babysitting, yard work, mothers' helpers, entrepreneurial endeavors, etc. Your records should include:

Type of work When the work was done For whom the work was done How much your child was paid You may be able to pay your child for work done around the house provided it is legitimate and the pay is at the going market rate (you probably won't get away with paying your son $150 an hour to mow the lawn, for example). If your family has a business, you can put your child to work doing age-appropriate tasks for reasonable pay. Your business minimizes its tax liability and your child earns income that will qualify him or her to make an IRA contribution.

Many parents choose to "match" their child's earnings and make the IRA contribution themselves. For example, if your daughter earns $3,000 at a summer job, you can let her spend her money as she wishes and you make the $3,000 IRA contribution with your own money. You might also offer to contribute a percentage of what your child earns, such as 50% (your child earns $3,000 and you contribute $1,500). Whatever approach you decide to take, the IRS doesn't care who makes the contribution as long as it does not exceed your child's earned income for the year. Since the contribution is made to your child's IRA, your child – not you – receives any tax deduction.

The Bottom Line

Young people have a tremendous advantage in time: even relatively small IRA contributions can grow significantly over time due to the power of compounding. In addition to the cold hard cash building in an IRA account, your child will have the added benefit of developing healthy financial habits: many financial experts and educators believe that the earlier children begin learning about money, the better their chances for financial stability in the future.