Saving and investing are the keys to long-term wealth. Unfortunately, “most Americans lack the discipline to save an adequate amount as a percentage of their income,” says financial advisor Sam Davis, a partner with TBH Global Asset Management. “So, inspiring savings early in a child’s life can really help.”
And one key tool to inspire: the Roth IRA. Because Roth IRAs allow for both tax-free growth and tax-free withdrawals, they offer a tremendous opportunity for young people. Kids have decades ahead of them to save for retirement. That puts them in the prime (and enviable) position to take full advantage of a long-term investment strategy, and the power of compounding.
Here’s why you should think beyond the usual savings accounts and savings bonds to consider opening a Roth IRA for your child.
Anyone of any age can open a Roth IRA. And anyone of any age can contribute to a Roth IRA provided they have “earned income.” Earned income, as per the Internal Revenue Service, is money that can come from wages, salaries, tips, bonuses, commissions, and self-employment.
That’s to say your child’s weekly allowance does not count as earned income. Instead, think entrepreneurial activities like babysitting, lawn-mowing, dog-walking, or salaried jobs like being a lifeguard or working at a fast-food franchise. Office work at the going market rate can count too if you have your own company.
“We commonly see business owners use this tactic because they can put their children on the payroll,” Davis says.
How much can go into the Roth IRA? As much as the child earned — within limits. The regular IRA rules apply: For 2022, you can contribute up to $6,000 a year if you’re younger than age 50.
The child needs to have earned income equal to the contribution amount. That means your child would need to have garnered at least $6,000 to make the full contribution. Otherwise, they can contribute up to the amount of money they actually made.
It can be difficult to convince a child to deposit their earnings into their Roth IRA. The good news is that it doesn’t necessarily have to be your child’s money that actually goes into the account. As long as your child meets the earned income requirement, you or anyone else can make the contribution – or a part of it — on their behalf.
“One idea that we’ve seen families implement that seems to be a good motivator is to implement matching funds,” says Davis. “Only invest for a child what they are willing to invest themselves.” So, for example, if your kid is willing to sock away $3,000, you can kick in another $3,000 to max out the contribution.
Normally, you can’t contribute to a Roth IRA if you make too much money: Above $204,000 annually (if you’re married) and $129,000 (if you’re single or head of household) in 2022. But in this case, no worries if your income is above the threshold. As far as the IRS is concerned, if your child has an IRA, it’s the child’s income that matters.
However, that cuts both ways. A key thing to remember is that you can’t invest a sum greater than the amount the child actually earned.
You can adopt this strategy with a traditional IRA, too. But the Roth version makes more sense for young people for three reasons:
Another thing to keep in mind is that unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) when you reach a certain age. That means the account can continue to grow for an entire lifetime, making it an ideal wealth-transfer vehicle.
If you’re ready to set up a Roth IRA for a child, the first step is to contact a brokerage that offers Roth IRAs for minors. Because the account is opened in the child’s name, you will need to provide their Social Security number. Some brokerages that offer IRAs for minors include:
Depending on the broker, there may be a lower minimum deposit requirement for the kid version. Fidelity, for example, waives a minimum completely.
Child IRAs work the same way as standard IRA accounts as far as the IRS is concerned. Of course, they are custodial or guardian accounts, which means an adult controls the assets in the IRA until the child reaches the majority age of 18 or 21 (depending on the state). After that, the account and all investment decisions are turned over to them.
Keep in mind that an IRA isn’t an investment itself; instead, it’s an account that holds the investments you choose, such as stocks, bonds, exchange-traded funds (ETFs), and mutual funds. Again, this is your job as a custodian, until the child is old enough to take over.
One potential downside of a Roth IRA for kids is that your child may eventually make too much money to continue funding the account. Of course, that’s not necessarily a bad position to be in — and even without additional contributions, the account will continue to grow tax-free.
Another consideration: The account will be in the child’s control once they come of age. They can do whatever they want with it, and you won’t be able to stop them.
Finally, don’t think of this as a tool for estate, Davis cautions. “For some families, it makes more sense to use trusts, family limited partnerships, and other advanced planning techniques when considering generational wealth matters.”
Setting up a Roth IRA for your kids now can help them secure a comfortable retirement later. By starting an IRA at a young age, your child can take full advantage of the power of compounding. After all, a single $6,000 investment made today could be worth more than a quarter-million dollars in 50 years, assuming an 8% annual return.
Moreover, a Roth IRA of one’s own can foster a lifetime of healthy money habits.
“It’s a great way to help educate their kids on the savings process while investing tax-efficiently,” says Davis.
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