If your child recently landed a summer job, congratulations are in order! Even better? That earned income means they are eligible to open an individual retirement account (IRA). If “my kid is way too young to be planning for retirement” just went through your head, think again, mom.
The IRA Basics
An IRA is a tax-advantaged savings vehicle to help people (yes, even kids) save for retirement. There are two types: traditional and Roth. The primary difference between them is when you pay taxes on the money contributed.
With a traditional IRA, taxes are paid at the time of withdrawal. So all funds (both contributions and any earnings accrued overtime) are “pretax.” But with a Roth IRA, taxes are paid before the contribution is made to the account, so the funds and earnings are “after-tax.”
The Case for the Roth
Thanks to their youth and the decades they have until retirement, children are especially well positioned to benefit from IRAs and the power of compound interest.
Since most children don’t earn enough money to exceed the federal limit for being deemed dependents, they’re in the 0% income tax bracket. Therefore, because they don’t have taxes to deduct from, most children won’t benefit from the upfront tax break given to taxpayers contributing pretax money into a traditional IRA. For this reason, a Roth IRA is a particularly good choice for children with limited income. It also allows them to grow their money tax-free and withdraw their money later in life without paying taxes.
In addition to tax-free withdrawals, a Roth also allows penalty-free withdrawals as long as the account is at least three years old. Therefore, Roth money can also be used for college, home purchases or major medical expenses, says Brix Gatti-Espejo, a financial advisor at Lifelong Wealth Management in California. “A Roth IRA is the number one thing I recommend to my clients, especially for youth.”
The Rules
Provided your kid has earned income—which can be anything from wages and tips to salaries and self-employment—they can contribute to a Roth IRA. That means lawn-mowing, dog-walking and babysitting all count. A weekly allowance? Not so much. But if you have your own business and your kid is on the payroll, that’s totally legit, too.
You (or anyone else) can also contribute to your child’s Roth IRA. However, you or your child can’t invest more than your child earned. For those under age 50, the contribution limit is $6,000 a year, but if your kid only earned $2,000, for example, contributions can’t exceed that $2,000.
Another great thing about the Roth is that there is no required minimum distribution (RMD), unlike with traditional IRAs. Typically, you have to start removing money from your retirement funds each year once you turn 72 (or 70 1/2 if your 70th birthday was before July 1, 2019). But with a Roth IRA, you don’t have to worry about that at all, and your kid’s account can grow for their entire lifetime.
How to Open One
Although some brokers advertise so-called Roth IRAs for Kids, there are few differences between Roth IRAs for children and those for adults (as far as the IRS is concerned). In general, though, Roth IRAs for children are custodial or guardian accounts—since your child is a minor, they need an adult (you) to control the assets until they reach the age of majority (18 in most states), at which point the account is turned over.
It’s simple to set up an account. Pick a brokerage that has Roth IRAs for minors—just keep in mind that some have minimum deposit requirements, aka the amount of money required to open the account—and open the account in your child’s name (which will require providing their Social Security number). And that’s it.
Your Kid’s Financial Future
Way to go, mom! You just took a major step in setting your child up for financial success. Teaching children to plan for the future and save for retirement from an early age will help them develop healthy, lifelong habits with money. Who knows, maybe they’ll also use some of that fortune to treat you in your old age.
Lorelai Yang is a freelance writer whose work has appeared in Fast Company, Eater New York and more.
LEARN MORE: How an IRA Might Lower Your Taxes