I recently discussed Roth IRAs in detail. That post was aimed at adults with earned income. One thing I didn’t discuss was the possibility of utilizing an IRA to help your children build wealth. It’s a powerful tool that is vastly underutilized.
Most people assume that IRAs can only be funded by adults. But no such restriction exists. Anyone can fund an IRA if they have earned income. Regardless of age.
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How does it Work?
You can setup a “custodial” Roth IRA for a youngster and manage the assets for them until they reach the age of majority (usually age 18, but up to age 21, depending on your state of residence). The money grows, undisturbed by taxes, for 50+ years. That’s a lot of compounding, tax free.
As the custodian, you make the decisions on investment choices until the child reaches the age of majority. At that time, you no longer have control over anything, and the account is completely owned by the child. They can spend the money in any way imaginable.
Not all firms allow minors to have IRAs, but most of the big ones are open for business. Including Vanguard, Schwab, Scottrade, T. Rowe Price, and TD Ameritrade.
Why the Roth IRA?
You could simply fund a taxable account that has been set aside for your child. You would technically own the account and could decide the appropriate time to gift the money. But there are a couple of major downsides to this approach. The first is that you will likely pay taxes on at least part of the investment earnings from year to year, slowing the compounding process. Second, the account would be included in your available assets and could impact your child’s ability to get financial aid in higher education. Third, there could be gift tax consequences at the time of gifting to your child.
All of these negatives can be eliminated by using an IRA in the child’s name.
Remember that contributions to a Traditional IRA accounts are tax-deductible in the current year. You receive a tax break equal to your marginal tax rate at the time of contribution. This is excellent for many working adults in a high marginal tax bracket, but not so much for a child.
Roth IRA accounts are funded with after-tax dollars. There is no tax break in the year that contributions are made, but all earnings grow tax-free and qualified withdrawals are tax-free.
For most young people, the Roth IRA is preferable to a traditional IRA for two reasons.
1) Children are typically in a very low tax bracket, and therefore don’t need the deduction that a traditional IRA provides. In fact, most kids are not required to file an income tax return because they have earned income that is less than the standard deduction amount ($6,200 in 2014). If that’s the case, it’s all taxed at 0%, which makes the Traditional IRA worthless.
2) Contributions to a Roth IRA can be withdrawn at any time for any reason without taxes or penalties. Furthermore, a portion of the account can be taken out for qualified expenses that might occur before retirement, such as qualified higher education expenses or a down payment on their first house, without penalty. I’m not recommending they raid the IRA account, but it can act as a wonderful backup emergency fund.
How Much Can Be Saved?
For 2014, the maximum contribution is the lesser of $5,500 or earned income for the year. If your child has no earnings, he or she cannot contribute at all.
Money from gifts, allowances or investment income does not count as earned income and, therefore, cannot be used towards contributions. Being a life guard or Walmart greeter certainly counts, but so does self-employment like babysitting, mowing lawns, flipping electronics on Craigslist, or cleaning houses.
Ideally, this income will come from sources other than family. Perhaps from jobs that provide a W-2. But that’s not necessary.
If the wage is paid by you or other family members, just keep records that include the type of work, the date of completion, the employer, and the agreed upon wage. You can include work done around the house provided it is legitimate and the pay is at the going market rate.
Better yet, figure out how to create a simple family business and put your child to work doing age-appropriate tasks for reasonable pay. For example, infants and children can be used for photography, video, and marketing purposes. They should be compensated appropriately for those services. In doing this, your business minimizes its tax liability and your child earns income that will qualify him or her to make an IRA contribution.
Another excellent option that I’m fond of is this: go ahead and match your child’s contribution each year. For example, if your child earns $4,000 at a summer job, you can let her decide between spending the money and saving the money. For each dollar that she saves, you match it. (She saves half of it, or $2,000, and you match $2,000 for a total IRA contribution of $4,000)
Or offer to contribute a percentage of what your child contributes, such as 50% (your child contributes $3,000 to the IRA, and you contribute $1,500 for a total of $4,500).
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.
They Will Thank You Later
Let’s consider a few scenarios to show the compounding magic of this strategy.
1) Ideal Scenario
Let’s assume you have just given birth to a picture-perfect baby and your family run a thriving photography business. You immediately start using the child in photos and videos for marketing purposes.
We’ll assume the going rate for baby marketing allows you to pay your child $5,500 per year, every year for 16 years.
In this case, you open up a custodial Roth IRA at Vanguard and fund the maximum $5,500 with the child’s earned income. Repeat each year for 16 years, then assume the child starts working and with your help, will continue maxing out the Roth IRA each year until retirement at age 65.
So we are funding the IRA with $5,500 each year, for 65 years.
- Compounding at 8% gets you to $10,972,654 at age 65.
If you assume 3% inflation, and plug the number into the following formula:
You get real growth of 4.85% each year, which compounds to $2,464,177.
2) Possible scenario
Same assumptions above, but instead you can only pay your child $2,000 per year for their photos.
In this case, you open up a custodial Roth IRA at Vanguard and fund $2,000 with the child’s earned income. Repeat each year for 16 years, then assume the child starts working and with your help, will continue maxing out the Roth IRA each year until retirement at age 65.
So we are funding the IRA with $2,000 per year for 16 year, then $5,500 each year, for 49 years.
- 8% compounding gets you to $5,994,751 at age 65.
- If you assume 3% inflation, you get $1,590,856.
3) Everyone Can Do This
The child starts working at age 15 and earns at least $4,000 per year.
In this case, you open up a custodial Roth IRA at Vanguard and fund $4,000 with the child’s earned income. Assume this continues for 50 years until retirement at age 65.
- Compounding at 8% gets you to $2,478,687 at age 65.
- If you assume 3% inflation, you still get real growth of $836,753.
It’s More than Money
Opening an IRA for your child obviously gives them a head start on saving for retirement. But more importantly, it teaches them a multitude of financial lessons covering the topics of taxation, investing, retirement, compound interest, and the dynamic relationship between earning, saving and spending.
Retirement might not be the first thing on a young child’s mind, but most kids are intrigued with the idea of money. You can help grow that small see of interest into something substantial. Young children may not understand the math behind compound interest or standard deviation, but they are old enough to appreciate a growing account balance.
As the child ages, you can educate them on the more difficult topics. You can sit down and show them the math behind compound interest, and the difference in account value that results from a 5% return on investment versus an 8% return. Explain why investment fees matter, the importance of diversification, and the differences between stocks, bonds, and cash.
Forget high school financial literacy courses. By age 18, your kid will be light years ahead of the average American adult.