It is possible to open an individual retirement account (IRA) for a child. However, there's one caveat: A child must earn their own income in order to open an IRA. That income can include money earned from self-employment work (babysitting, shoveling snow, walking dogs, mowing lawns, for example) or formal employment.
When it comes to formal employment, children must be at least 16 years old to start working legally, unless they're working for a business solely owned by their parents or guardians (with some exemptions).
- If you open an IRA for your child, it will be a custodial account until your child is of legal age.
- If the child earns less than the IRA contribution limit, then the IRA contribution limit is capped at the child's total annual income.
- Roth IRAs may be attractive for young people because their current tax rates are likely low, and qualified Roth withdrawals are tax-free.
- IRA contributions may be tapped for qualified college expenses without penalties but could impact the child's income for financial aid purposes.
Opening an IRA for a Child
If you want to open an IRA account for a minor, it must be a custodial account, meaning it's held by the parent or guardian in the name of a minor. That parent or guardian maintains control of the account until the child is of legal age, which varies by state but is usually either 18 or 21. The account must be transferred to an independent account in the child's name as soon as the child reaches the age required by your state. There's usually no minimum amount required to open a child's IRA or Roth IRA account, but certain investments may require a minimum initial investment.
To open a custodial account for your child, you'll usually need to provide the following:
- Your identifying information (e.g., date of birth and Social Security number)
- The child's identifying information
- Your contact information (mailing address email address, phone number)
- Your employment information
Contributing to a Child's IRA
Contribution maximums for children's retirement accounts are the same as those for adults. The IRA contribution limit for 2020 and 2021 is $6,000. However, there is an additional exception: Contributions can't be more than a child earns for the year. So, if they earn $2,000 for babysitting and walking dogs during the year, then their IRA contribution can't be more than $2,000.
As you have to get your child to contribute some of their own earnings, the toughest part of opening a child's IRA account could be convincing them to stash away today's money for their golden years.
As an alternative, you may also choose to make a contribution to your child's account based on their earned income. You can also choose to match your child's contribution, as long as the total doesn't exceed the amount they earn or the contribution maximum for the year—whichever is lower.
Roth IRAs for Children
For kids, in particular, a Roth can be beneficial because they're paying today's taxes on future investment growth.
Roth IRA contributions are made after taxes, meaning that account holders can take advantage of years of tax-free compounding. In addition, you pay no taxes on qualified distributions from a Roth at retirement.
If needed, account owners can also make early withdrawals from a Roth IRA. However, if they choose to go this route, they should be aware of the special Roth withdrawal rules to ensure they don't get penalized.
Generally, qualified distributions are those you take after you turn 59.5 and satisfy a five-year account holding period. Nonqualified distributions may be subject to ordinary income taxation and an additional 10% tax for early withdrawal unless you qualify for an exception to the 10% penalty. Note: Since contributions are made with post-tax dollars, only the earnings portion would be subject to ordinary taxation.
Why Open an IRA for Your Child
IRAs for kids are not a widely understood concept, but they can be a great strategy to encourage investing in a tax-advantaged account at a young age. Contributions can add up quickly, and earnings potential rises exponentially the earlier you start as an investor in a tax-sheltered account.
Plus, with an early IRA or Roth IRA, you are setting your kids up with a financial life that they can build upon and learn from a few years earlier than their peers. Experience like that can be invaluable in helping your child make wise financial decisions.
IRAs and College
Both traditional and Roth IRA contributions can be withdrawn penalty-free to pay for qualified education expenses. And withdrawals of contributions from Roth IRA are also tax-free. However, there is a downside to using a retirement account to save for college.
Having an IRA or Roth IRA in either your name or your child's name won't affect their chances for financial aid. However, distributions from an IRA are considered when determining need on the Free Application for Financial Student Aid (FAFSA). Generally, parents should be using their IRAs or Roth IRAs to save for their own retirement, not for college.