I’ve written before about the benefits of teaching your children about financial planning topics and money management, and also noted how you can help them create a positive credit report history and score. Another advantage you can give your kids is to help them invest in a Roth IRA when they start earning income from their first job.
Why should your child invest for retirement?
Compounding. The sooner you start investing, the more you can accumulate with the same investment. Here’s an example from The Motley Fool: if your child invested $1,000 at age 25 and earned 8% annually, the investment would be worth almost $22,000 at age 65. But if they started at age 15? That same investment with the same return would be worth almost $47,000. And that’s with just $1,000.
Financial education. While you can teach your kids about money, having them create a budget or making them choose between two things they want brings the lesson home. The same is true with investing. Take the time to show your child how you select the brokerage (fees, access to funds, etc.) and how you evaluate the investments for their account. If they are old enough, let them do some of the research and choose the investments on their own.
Why a Roth IRA
Tax advantages. The main difference between a Roth and traditional IRA is with a Roth, you pay taxes before you contribute money into the account and withdrawals are tax-free; with the traditional IRA, you can use pre-tax money to invest, but then pay taxes when you withdraw the money from the account. As you can imagine, most children wouldn’t earn enough money to take advantage of the tax deduction associated with traditional IRAs.
Access to contributions. Many people worry that investing in an IRA means you won’t be able to access your money. Even with a traditional IRA, you can access your money, but will end up having to pay the taxes you saved when you invested plus a 10% penalty. However, with a Roth, you’re investing after-tax money. This means if your child needs the money for college expenses or help purchasing a house, they can withdraw their contributions with no penalty. Obviously you want to keep the money invested for retirement, but it’s nice to know it’s available if they need it.
Things to keep in mind
Contribution limits. Contributions for a child’s account can be no more than the IRA limit – $6,000 for 2021. Even if your child makes $10,000 they can only invest $6,000. Additionally, the contribution is limited to the actual money the child earned. So if your child only earned $2,500, you can’t add more as a gift. Their limit is the amount they earned. Note that this is earned money from any type of job. So if your child makes $20 in cash for pet sitting or raking leaves, that can go towards their retirement. If they don’t receive a paycheck, it’s a good idea to keep records of their income, just in case the IRS has questions.
You can fund their account. While the contribution limits are tied to their earnings, your child doesn’t have to take every cent they earned and invest it for retirement. A parent can fund their account. One goal we’ve set for our two teenagers is to fund their first IRA up to $5,000. We have no idea how long it will take for them to earn that amount of money, but we plan to invest for their retirement as soon as they start earning money and continue until each has $5,000 in their account.
However, take this with a grain of salt. If your retirement is on thin ice and you haven’t fully funded your own IRA or workplace 401k, it might be a better idea to invest in your retirement (since it’ll be here sooner) and help your children down the road.
Your child owns this account. Even if your child is under 18 (or 21 in some states), they own the account. It will be a custodial account that you set up, but at the age of majority the account will be changed over to their name. They will have full control of the money in the account. Yes, that means they could withdraw all the money and spend it on a vacation to the Bahamas.
Opening the Roth IRA account
Most mutual fund companies and brokerages offer custodial IRAs with no or low minimums and account fees. If your brokerage doesn’t, consider researching others or go directly to a fund company. However, know that certain mutual funds require minimum deposits, often $1,000 or more. And as with any other investment, keep an eye on fees. Your child could have this account for 50 years or more.
Additionally, if you are opening a custodial account you will need information for both the parent and child (Social Security numbers, address information, etc). Even if your child is old enough to open the account on their own, help them find the best investment company for their needs and assist them in creating an investment plan for these funds.
Many people don’t consider their kid’s first job as an avenue to save for retirement. But if you’re able to do so, funding their initial IRA can help your kids become confident and successful investors for life.
Photo by Andrea Piacquadio