If you have a child who earns money, the last thing you want is for him or her to blow that cash on nonsense. Therefore, teaching that child to save at a young age is crucial. And while you could encourage your child to stick that income directly into a savings account, you might consider a more potentially lucrative alternative: an IRA.
When we think about people funding IRAs, we tend to imagine working adults who are looking to sock away money for retirement. But the reality is that anyone with earned income can contribute to an IRA (though traditional IRAs bar contributions once you reach 70 1/2). Therefore, if your kids have money from an after-school or summer job, it pays to help them reap the benefits of opening a retirement account.
IRA types for kids
If your child has earned income, there are two options for opening an IRA: the traditional and the Roth. With a traditional IRA, your money goes in tax-free, but when you take withdrawals in retirement, they're taxed as ordinary income. With a Roth IRA, your money goes in on an after-tax basis, but when you take withdrawals, they're yours free and clear of taxes.
With either account type, you don't pay taxes on your investment gains year after year. With a traditional IRA, that growth is tax-deferred, which means you only pay taxes when you take withdrawals. And with a Roth IRA, that growth is completely tax-free.
Since many children don't earn enough money to be liable for income taxes, it generally makes more sense for them to opt for Roth IRAs, since they don't get to enjoy the immediate deduction associated with traditional IRAs. And this way, they get to reap the numerous benefits associated with Roth IRAs.
Why open an IRA for a child?
If you have a teenager with a modest income, that child's retirement is probably the last thing on your mind. But what you may not realize is that you have a great opportunity to capitalize on long-term growth on your child's money.
Imagine your child is able to contribute $2,000 to an IRA at age 17. If his or her investments then deliver an average annual 7% return over the next 50 years (which is more than doable with a stock-heavy portfolio), by age 67, that sum will have grown to $59,000. Best of all, if that money is in a Roth IRA, your child can enjoy that $57,000 gain without having to pay a dime in taxes.
Another good reason to open an IRA for your child is that it's an opportunity to get him or her started with investing. IRAs tend to offer a wide range of investment options, so you can explore those choices with your child and devise a strategy that works for you. And this way, your child will be more inclined to start investing regularly once he or she enters the workforce full time.
Finally, though IRAs are designed to provide retirement income to seniors, they can also be used to pay for college. This holds true whether you have a traditional IRA or a Roth (though be advised that having an IRA might impact your child's financial aid eligibility).
With a traditional IRA, you're generally penalized for withdrawing funds prior to age 59 1/2, but if you use that money to pay for college, that penalty is waived. Meanwhile, if you have a Roth IRA, you can actually withdraw your principal contributions at any time without getting penalized. The logic is that since you never received a tax break on that money, you're not as restricted. Of course, this isn't to say that your child shouldn't aim to keep that money locked away in his or her IRA for the long haul. But if that money is needed for college at some point, that's a good reason to take a withdrawal outside of retirement.
The fact that your child is earning money shows a degree of financial responsibility, so why not take things one step further by getting that cash into an IRA? The sooner you teach your child the importance of saving for the future, the more inclined he or she will be to follow your great advice for many years to come.