It's never too early to teach kids about finances and help them start saving for their own retirement.
Parents want what’s best for their kids. It’s why they tell kids to brush their teeth, assign them chores, and sign them up for character-building extracurricular activities.
When it comes to money, parents also want their kids to tread on the right path. They might talk about the importance of saving up for major purchases or for college. They may offer them allowances to help them learn to manage money on their own. They may even buy games related to finance to give kids a sense of how cash flows.
But parents often fall short when it comes to helping their children understand the more complex topic of building wealth for the long term through investing.
“By the time your child has a summer or high school job, it’s important to have the conversation about saving for retirement,” said Dara Luber, senior manager, retirement at TD Ameritrade. “A traditional or Roth IRA for a child can be a great tool to help them see the impact of saving and investing for retirement.”
With IRAs of their own, children can see firsthand how these retirement accounts can work in favor of their financial health over time.
An IRA can be a good way to help children start saving for retirement with their first job and to teach them about how savings habits can payoff through the power of compounding.
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. When you withdraw funds from a traditional IRA, you must pay tax on any gains.
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 minors, such as those who hold part-time or summer-only jobs, have annual incomes that fall below the taxable threshold. In such cases, contributions to a Roth IRA could be essentially tax-free on the way in as well as on the way out.
To open a traditional or Roth IRA for minors, you’ll 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 that’s 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. Because the account is in your child’s name, you’ll need his or her tax identification number, which is usually the Social Security number. Keep your own information, including your Social Security number, handy just in case you need it.
There’s no age restriction on a traditional or Roth IRA for kids. If your 5-year-old child earns money, 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 have to potentially take advantage of the power of compounding.
Like with any IRA, an IRA for a minor comes with contribution caps. For the 2019 tax year, you can add $6,000 per year to an IRA, but you won’t be able to put that much into an IRA for your child if he or she doesn’t earn above that threshold.
“Contributions are also limited by how much earned income your child has,” Luber pointed out. “If your kid makes $3,000 as a lifeguard over the summer, and doesn’t make any other money during the year, that’s the limit.”
Earned income, for the purposes of a traditional or Roth IRA for kids, includes money from any job that 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, as long as you pay them a reasonable wage.
You and your child can both make contributions, but your combined annual contributions can’t exceed either the child’s total earned income or $6,000, whichever is lower.
“A really great strategy is to introduce a match,” suggested Luber. “Tell your kids that if they put in money from their jobs, you’ll match with your own money. This encourages them to take an interest in their futures and how well their investments are doing.”
A traditional or Roth IRA for minors can be an ideal way to help your child build 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 growth.
As your child’s portfolio grows, you can help identify where successful investment choices were made and where less successful 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 grow 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 nest eggs on their own.
“Most kids won’t get a pension like their grandparents did,” said Luber. “You need to start prepping them now for a successful retirement.”
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
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