Investing for Your Kids

The IRA Options

Investing for Your Kids

There are three main kinds of IRAs. Traditional IRAs, Roth IRAs, and Education IRAs.

But let's start with first things first: what's an IRA? It stands for Individual Retirement Account, and it's something that the government has created to enable the likes of you 'n' me to squirrel away money for the future. It encourages us to do this by giving us tax breaks.

Traditional IRAs

The tax breaks for a traditional IRA are of the 'this is tax-deductible' kind. That means that whatever money you deposit in your IRA isn't taxed. You made $30,000 during the year, and you put $2,000 of it into an IRA? Then you're only taxed on $28,000. When you withdraw the money for your retirement -- after age 59 1/2 -- then the money will be taxed as income at your then-pertinent tax rate.

If you withdraw the funds before age 59 1/2, then in most cases you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- but if the funds are used to pay for "qualified higher education expenses," then the penalty will be waived. (For more detailed information on IRAs and penalties for early withdrawal, read our Foolish Retirement Plan Primer.)

There are also non-deductible IRAs (if your income is over a certain limit, and you are a participant in a qualified pension/profit sharing/retirement plan). This, however, is something that would most likely not apply to a child.

So: can you open an IRA for your child? Not exactly.

In order to have a traditional IRA, the owner of the account must have earned income. That means that you cannot open one of these for your child, until she is actually earning income. If your little kaboodle has begun, at the age of four, child modeling; or if you've decided to submit her for some friendly (and paying) medical experiments (shame on you!) then she qualifies. She can have an IRA for her earned income, up to $2,000 per year.

An IRA account for your child is very similar to, but not exactly the same as, a custodial account. That is, you control the account until your child reaches the age of majority -- just as you would with a custodial account -- but the IRA account is not actually considered to be a type of custodial account. It's a different animal, in the eyes of the law. It's close enough, though, that it makes sense for us to present it here as part of the "I am prepared to turn the money over to my child when she becomes an adult" option.

Now, right here, let's steal a little thunder from Step 5 and let out a secret: you can put just about anything you want in an IRA account. Why is this a secret? Well, it isn't. However, under the onslaught of marketing from banks, you may have wilted to the conclusion -- held by many! -- that an IRA is somehow connected to a CD (certificate of deposit). This is because that is what most banks sell.

But be advised, Fool: you're not limited to what the banks offer. Not at all. If your outlook is Foolish, and you'd like to take control of your investing future, and you think you can develop some market-beating returns, then by all means, plunge ahead, with IRA and tax savings happily in hand! (More on this in Step 5, of course).

The Roth IRA

The tax breaks for a Roth IRA are different. Again, you can put in up to $2,000 a year. But the money isn't tax-deductible. Taking the above example, you'd still be taxed on $30,000 even though you had put the same $2,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, it isn't taxed. That's right -- you get off scot-free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as it's been in there for at least five years.

The same limitation applies in regard to your children: they can't own one unless they're earning income. So put kiddie to work if he really wants his own IRA. Encourage him to load up his bicycle baskets and take on a newspaper route, or to clerk at the local candy shop, or to pick up a cheesecloth and get a job buffing bright BMW's (one of which, with his earnings, he'll one day buy) at a nearby established car wash.

As a practical matter, you're probably going to want to choose the Roth IRA rather than the traditional IRA for your child. Both the Roth and traditional IRAs are primarly retirement vehicles. However, the Roth is more flexible: you can withdraw any contributions (as opposed to earnings) for any reason, without tax or penalty.

The Education IRA

The Education IRA is in a category all its own. You could have a traditional IRA as well as a Roth IRA, but you could only invest a total of $2,000 yearly into both of them. The $500 maximum that you could invest yearly in an Education IRA is in addition to that $2,000. (As of this writing, there is a movement afoot to get that $500 per year limit raised to $2,000 per year. However, right now that raised limit is but a gleam in the eye of brokers and lobbyists.)

The $500 contribution you make is not tax-deductible but, like the Roth IRA, you can withdraw it tax-free for your child's college education. (As a matter of fact, it can be transferred to another family member if the one for whom it's intended doesn't use it. It still has to be used for education, though.) You control the money; in this way, it's very similar to a guardian account.

Just make sure that it's used for your child's college, or there'll be penalties to pay.

Next let's look at your other non-IRA options.

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