What we’ll cover:
Some parts of childhood require waiting.
You’re just not old enough is probably something you’ve told your child before.
So it may surprise you that saving for retirement isn’t something your kid needs to age into. If you have a minor earning an income, they can already start building their retirement fund with an IRA.
There are two types of individual retirement accounts (IRAs) you can open for a kid: Traditional and Roth.
There are several differences between a Traditional IRA vs. a Roth IRA, but in short, here’s the big takeaway:
And while both technically are an option for your child, we’re going to focus on Roth IRAs.
There’s really no such thing as a “Kids Roth IRA” account – it’s just a regular Roth IRA that parents establish for their child.
Here’s how it works in a nutshell: money is added to the account with post-tax income that your child has earned, that money grows over time, and then your child gets to withdraw the money tax-free in retirement.
The benefit of tax-free withdrawals tends to be the main reason Roth IRAs are recommended for children. Just keep in mind that there are certain rules you’ll need to follow (see below).
If your child wants to enjoy tax-free withdrawals, they will have to hold the account for at least five years and wait until they turn 59 ½ before tapping into their money. Since we’re talking about opening a Roth IRA for a kid, the five years should be a lock.
Waiting until 59 ½ takes a bit more discipline, but the payoff could be tremendous. (See example below).
We thought you’d never ask.
Let’s look at an example of how your child could really grow their retirement savings by investing early on.
Say your child contributes $50 a month of her post-tax earnings each year to her Roth IRA from age 10 to 21. After that, you might encourage her to up her retirement game since, we’d like to assume, she’ll probably be making more money. But back to her childhood…
Since a Roth IRA requires you to pay taxes upfront, that $50 monthly contribution has already been taxed, and from age 10 to 21, she’ll have contributed a total of $7,200 dollars. Not too shabby.
And when you account for the power of compounding – which is essentially making money on your money – she’ll have even more stashed away in her nest egg. Assuming she doesn’t touch that money and gets an average 8% rate of return on her contributions, her money will have already grown to over $12,000 in those 12 years. And remember, this is (in theory) tax-free money!
Most IRAs offer a variety of ways to invest money, depending on one’s goals and risk appetite. Stocks, bonds, mutual funds and exchange traded funds (ETFs) are just some of the popular options, for example.
Even though the goal is to enjoy tax-free money in retirement, Roth IRAs offer more flexibility than other retirement accounts – say a Traditional IRA or 401(k) – when it comes to withdrawals.
Your child can withdraw her Roth IRA contributions at any time, for whatever reason, tax-free and penalty-free. This means that if at 28, your child decides she wants to use her retirement savings for a down payment on a house, she absolutely can do so. The contributions she’s made are entirely hers to take back.
That being said, she may have to pay taxes and penalties on her earnings (the money she’s made on her contributions). If she makes an early withdrawal (before she reaches 59 ½), she could be dinged with a 10% early distribution tax and/or her earnings may be taxed as income.
While Roth IRAs offer early withdrawal flexibility, they don’t actually require that account owners withdraw their money past a certain age. This is not true for other retirement plans, which typically require you start taking distributions at a certain age.
Additionally, Roth IRA account owners can contribute to their account indefinitely, which is also not the case for other retirement plans.
You’ll see some accounts marketed as a Roth IRA for Kids but what you’re really setting up is called a custodial account. The account would be in the child’s name, but the adult – parent or guardian – would be in control of the Roth IRA until the child is legally considered an adult, which is typically 18 or 21, depending on your state. Once your child is considered a legal adult, the assets in the account must be transferred to a new account under your child’s name.
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