If you have kids, thinking about your own retirement may seem like something that will happen in the distant future. So, it's understandable that their retirement could be the last financial issue on your mind, but maybe it shouldn't be.
Opening an IRA -- and particularly a Roth IRA -- for your children could be an extremely wise financial move. In addition to helping them get a head start on retirement saving, a Roth IRA can help them learn the basics of investing and could also help them save for emergencies or college expenses in a tax-advantaged way.
However, there are a few things you need to know before you open an account for your child and make a contribution. Specifically, there are certain qualifications that need to be met, so here's a quick guide to Roth IRAs for kids to make sure you get started the right way.
Why you may want to consider a Roth IRA for your kids
A Roth IRA is an after-tax retirement account. That means you don't get a current-year tax deduction for your contributions, but your investments are free to compound year after year without capital gains or dividend taxes, and qualified withdrawals will be 100% tax-free.
However, children are generally in the lowest tax brackets and therefore don't really miss out by not being able to deduct their contributions. To be clear, minors who earn income can contribute to a traditional IRA if they want to -- but the tax structure of a Roth IRA typically makes far more sense.
Because kids generally have little or no tax liability, a Roth IRA can be an excellent way to maximize the most powerful asset they have -- time. Since Roth IRA investments grow tax-free, the long-term compounding power of stocks can produce some pretty phenomenal returns.
For example, let's say your child is 15 and that you contribute the annual maximum to a Roth IRA in their name -- which is $5,500 for 2018. Based on the long-term total return of the S&P 500, this investment could grow to a staggering $645,000 by the time your kid is 65. And this is just one year's contribution. Imagine if you max out your kid's Roth IRA contribution for a few years in a row.
There are some other nice benefits to a Roth IRA that could come in handy for your kids. Just to name a few:
- Roth IRA contributions (but not any investment earnings) can be withdrawn at any time and for any reason, without penalty. So a Roth IRA can be a great emergency fund for your kids, in addition to a great retirement savings vehicle.
- Roth IRA funds can be used for qualifying college or other educational expenses penalty free. So, a Roth IRA can help your kids (or even their kids) with college costs.
- Up to $10,000 in investment earnings from a Roth IRA can be withdrawn tax- and penalty-free toward a first-time home purchase. This is in addition to the ability to withdraw any contributions to the account.
- A Roth IRA can be a great way to teach your children about saving and investing. By learning the ins and outs of retirement saving under your direction, they'll be better-equipped to save and invest for their retirement once they're out on their own.
What are the requirements to contribute to a Roth IRA?
So far, we've discussed why you might want to contribute to a Roth IRA for your kids. Now let's look at whether you can contribute to an account.
There are a couple of basic requirements that need to be met before Americans can contribute to a Roth IRA.
- First, their income needs to be below a certain threshold. For the 2018 tax year, the maximum modified adjusted gross income (MAGI) you can have is $199,000 if you're married and filing a joint return, or $135,000 if you file as single. As you can probably imagine, this is typically not an issue for children.
- Second, the annual contribution limit is $5,500 or your total earned income for the year, whichever is lower. Earned income means money from a job or from a business you own and actively participate in -- not interest income, dividends, or other passive sources. This is the requirement that is typically the potential roadblock for children, and I'll discuss it further in the next section.
The takeaway so far is that your child needs to earn income to make a contribution. However, it's important to emphasize that it doesn't necessarily need to be your child's money that is contributed -- in other words, as long as your child has enough earned income to justify it, there's no reason you can't make a Roth IRA contribution on your kid's behalf or match some of the money he or she contributes.
You may also need to serve as custodian of the account until your child turns 18, as brokerages generally don't allow minors to open their own accounts. At least one broker, Fidelity, has introduced a kid-focused Roth IRA product to make the process as easy as possible for parents.
"Earnings" and "job" are two different concepts
Here's an important point. One of the requirements, as mentioned, is earned income. But that does not mean your child necessarily needs to have formal employment. Self-employment income also qualifies, as long as it's reported to the IRS. (Note: If your child earns more than $400 from self-employment in 2018, he or she is legally required to file a tax return.)
For example, if your 14-year-old child earns $1,000 mowing lawns this summer, this income could be used as the basis for qualifying for IRA contributions. Other potential qualifying income sources are babysitting, or even chores you pay your kid for doing. (Note: I am not a tax professional. Be sure to consult one if you have any questions about what income qualifies for Roth contributions.)
One caveat is that by using self-employment income as a basis for qualification, your child may also have to pay self-employment tax on his or her reported income. Again, consult a tax professional to determine the potential tax implications of opening a Roth IRA for your child. Even if this is the case, the long-term benefits of Roth IRA investment at such a young age can more than offset this expense. And as I mentioned, if your kid earns more than $400 for the year, he or she should be reporting self-employment income anyway.
If they qualify, a Roth IRA can give your kids a head start on savings
To sum it up, not all kids qualify for Roth IRA contributions, but if they do, investing in a Roth IRA at a young age can help set them up for a lifetime of tax-free compound gains. They'll never have more of a time advantage then they do right now, so a Roth IRA can give them a big head start on the road to financial freedom.
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