If you want to give your child a jump start on investing, establishing a Roth IRA for them is a great place to start. You can teach them the value of saving and investing, plus they'll get the benefits of extra time for their money to compound. Opening a Roth IRA for kids under 18 is allowed, but there are certain rules you have to follow. Here are five things to know before you start helping your kid save for their retirement.
1. They need earned income
Anyone who funds an individual retirement account (IRA) needs to have earned income, including children. Earned income means they have to make money by working. If they have trust income, that doesn't count, for example. If your kid makes money from doing jobs like babysitting or lawn-mowing, that income could count. But be aware that they could have to pay the 15.3% self-employment tax.
Additionally, contributions can't exceed earned income for the year. So if your child earns $3,000 in a year, $3,000 is the maximum amount that can be contributed. It doesn't matter who makes the contribution, but it can't be more than the child's earned income.
2. Their age doesn't matter
There's no minimum age for contributing to a Roth IRA. Eligibility is based on income. If your toddler makes money on Instagram as an influencer -- yes, that's a thing -- they're eligible for Roth IRA contributions. However, minors typically can't open a brokerage account, so you'll need to open a custodial Roth IRA on their behalf.
3. The regular contribution and income limits apply
Minors are subject to the same Roth IRA contribution limits as adults. For both 2020 and 2021, the maximum contribution someone under 50 can make is $6,000. The same Roth IRA income limits also apply, though these usually aren't a problem for the under-18 crowd. A single person can contribute the full $6,000 if their income is under $124,000 in 2020 or $125,000 in 2021.
The deadline for making contributions for any year is the day tax returns are due, so you can make 2020 contributions until April 15, 2021.
4. If you employ them, keep the pay "reasonable"
If you're a business owner, you're allowed to hire your child and use their wages to qualify them to fund a Roth IRA. But they need to be a legitimate employee. This means no putting your 3-year-old on the payroll and saying they earned $6,000 for the year as your "assistant." But if you own a store and have your teenager working the cash register, that's allowed -- so long as the wages are "reasonable" in the eyes of the IRS. Overall, they shouldn't be earning more than you'd pay a stranger to do the exact same job.
5. You'll manage the account, but they'll own it
Your child is ultimately the owner of the account. However, since minors can't open their own IRAs, you'll need to serve as the custodian of the account until your child reaches age 18 or 21, depending on your state. As custodian, you'll be responsible for investment decisions, and you must invest that money for their benefit. Once they reach the minimum age of 18 or 21, the account will need to be transferred to a new account in their name. Like it or not, that means the money will be 100% theirs to control.
Should you open a Roth IRA for a child?
If your child invested $1,000 at age 25 with 8% annual returns, that investment would be worth nearly $22,000 by the time they're 65. But if they invested that $1,000 at 15? That investment would be worth almost $47,000 by age 65. Plus, Roth IRA contributions are made after taxes -- since kids usually don't have much income, they're taxed in the lowest brackets. Then, the money grows tax-free, and withdrawals are also tax-free once they reach age 59 1/2, no matter how high their marginal tax rate is by then.
But you can only afford to worry about your child's retirement if your own retirement accounts are healthy, especially if you'll be making the contributions. Assuming that's the case, it's hard to argue with the financial benefits of a Roth IRA for kids.