You've probably heard time and time again that the earlier you start saving for retirement, the better. So why not help your kids start to save for retirement as young as possible? Giving them a 40- to 50-year head start on retirement can really pay off for them down the line.
Let's go over a smart way to set your kid up for a comfortable -- perhaps even early -- retirement.
IRAs for minors
If your child is under the age of 18, you can open a custodial IRA for them at any of several brokerages. The account will be in your child's name, but you control the money inside it until your kid becomes a legal adult at age 18 (note that in a few states, the legal age for adulthood is 19 or 21 instead).
The contribution rules for custodial IRAs are the same as for adult IRAs: Minors needs to have earned income in order to contribute, and their contributions are limited to the lesser of $5,500 (for 2017) or their earnings for the year. You can also contribute money to the custodial IRA on your child's behalf, but the total contributions for the year still can't exceed those limits. Still, contributing some money to your kid's IRA in the form of a "match" may motivate them to contribute a bit more.
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What an IRA can do for your teenager
Even a few thousand dollars in your kid's retirement savings account can yield enormous benefits once they reach retirement. For example, say your child's IRA has $10,000 in it by the time they reach age 18. Assuming a 6% average annual return on that money (which is a fairly conservative return for stocks), by the time your teenager reaches full retirement age at 67, that $10,000 will have turned into about $170,000. That's a pretty darn good boost to their retirement income.
Traditional or Roth IRA?
When you open your child's IRA, you can choose either a traditional or Roth account. Roth IRAs are nearly always the best choice for kids for several reasons. First, traditional IRAs give you a tax break on the money you contribute to the account, while Roth IRAs give you a tax break on the money you take out. Because teenagers don't generally earn enough money to need a tax break right now, they're better off getting the tax break when they retire and their income will be much higher. Second, you can withdraw the contributions made to a Roth IRA (but not any earnings) before hitting age 59-1/2 without having to pay a penalty tax. That can make a Roth IRA a bit easier to sell to your teenager. And third, Roth accounts are not subject to required minimum distributions (RMDs) during retirement, giving your child much more control over how much money to withdraw and when.
What to do with the money
For a teenager, stocks are the best way to go, because they produce much higher long-term return than bonds. Their main drawback is the fact that they are far more volatile (meaning that they can suffer huge up and down swings in value), but that's a pretty minor issue when you're at least 40 years from retirement. The investments in your child's IRA will have ample time to recover from any market crashes that happen between now and when that money is needed.
The simplest way to invest in stocks is to pick out a low-cost S&P 500 index fund and put all your child's money in that. An index fund typically has much lower fees and other expenses than an actively managed fund, meaning your child gets to keep more of those annual returns. And an S&P 500 fund gives the account a decent level of diversification.
When you first bring up the subject of contributing to an IRA, your teenager may balk at the idea. After all, teenagers typically have much more entertaining things to spend their hard-earned money on. But once you sit down with your kids and show them how much money they could end up with as a result (and maybe promise to make some contributions to the account yourself), you might find it easier to talk them into contributing at least a small part of their money. Not only will you give them an excellent start on their retirement savings, but you'll help them build good financial habits that can benefit them throughout their entire lives.
