Most people open individual retirement accounts (IRA) once they get their first full-time job–typically in their early-to-mid 20s. But if your child begins working at any point before then, starting a simple IRA for them during childhood can give them a huge jump on building significant retirement savings for the future, regardless of how young they may be.
A retirement savings account for a five-year-old child may seem like a crazy notion, but Custodial IRAs allow a parent or guardian to open such accounts on behalf of a minor at any age, as long as the child has begun earning income that is reported and taxed by the federal government. Compounded growth means the earlier an IRA is started for your child, the more interest it will bear. For example, an initial $6,000 investment into an IRA for a 10-year-old child made now (the maximum contribution the IRS currently allows for anyone under age 50), based on an annual five-percent rate of return, would grow to just shy of $69,000 by the time that child is 60-years-old. And that’s without making any additional contributions.
Though the earnings generated by these IRA accounts cannot be touched until retirement age without penalties, once the children are no longer considered minors (definition varies by state), contributions made to these accounts can be withdrawn penalty free and tax free for purposes such as paying for college or helping to buy a house.
While getting a child to willingly put money they have earned into an IRA may not be easy, that doesn’t mean you should abandon the idea. That’s because others, such as parents or grandparents, are able to make contributions into these accounts on behalf of the child whose name they are in, as long as the amount being gifted doesn’t exceed the amount the child has earned during that tax year. If your child receives a Form W-2 from their job, the W-2 would be sufficient to show the amount of their income that can be put into a Custodial IRA. If, however, the type of work your child does is less conventional, such as babysitting, mowing lawns, etc., then you will want to keep records such as receipts. In order to qualify, the work a child does must be legitimate, as opposed to just allowances paid for chores around the house.
Types of IRAs
As with normal IRAs, there are two types of Custodial IRAs available: traditional IRAs (where contributions are tax deductible) and Roth IRAs (where taxes are paid up front, but disbursements taken at the point of retirement are tax free). Given that minors typically do not earn enough to benefit from a current tax deduction, Roth IRAs make the most sense when it comes to Custodial IRAs.
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