IRAS: They're not just for adults anymore! While it's no secret that IRAs — individual retirement accounts — are a popular way to save money for retirement, many don't realize that these savings accounts can also be an effective investment tool for children and teens. As long as a child is earning income from a job, they can contribute to an IRA.
There are two types of IRAs that investors can take advantage of for children. Read on to learn more about how to use IRAs to help young people start saving and investing.
IRAs: Part of a Comprehensive Financial Plan (for Kids)
IRAs offer a number of benefits for younger people. These retirement investment accounts work most effectively given a long time horizon... and that's exactly what young investors have. Given their age, children can take full advantage of the power of compound interest for many years. One caveat: Children must be making an income in order to contribute. No, allowance doesn't count... but meticulously documented income from, say, a babysitting, dog walking or lawn care job does.
Children may have two types of IRA: Roth and traditional. What's the difference? The primary distinction between the two types lies in when taxes are paid; with a Roth IRA, taxes are paid at the time money is contributed to the account. With a traditional IRA, taxes are paid when money is distributed during retirement, also known as pre-tax earnings.Either way, the invested funds grow tax-free while they're in the account. However, a Roth IRA will allow your child to avoid paying income tax when they withdraw money years in the future.
In general, most children won't make enough income to reap substantial benefits from traditional IRA's up-front tax deductions; in 2017, the cut-off for filing an income tax return (0 percent tax bracket) is $6,300 per year. If your child is claimed as a dependent and makes less than this, in most cases it probably makes more sense to open a Roth IRA rather than a traditional IRA. If a child maintains a Roth IRA until age 59 1/2, they'll enjoy tax-free distributions. Given that they'll likely be in a much higher tax bracket by the time they retire, a Roth IRA will allow them to keep more of their money.
Retirement Planning: Benefits of IRAs
Obviously, an IRA will benefit your child by providing them with a head start on saving for the future and allowing them to grow their savings through compounding interest over time. But retirement planning advisors point out that IRAs offer other benefits for children, as well. Many accounts can be opened with a small initial investment, making it easy for children to enter the world of investing.
An IRA offers an ideal opportunity for kids to learn about wealth management issues such as:
- Retirement planning
- Compounding interest
- The connections between earning, saving and spending
Though such issues might be the last thing on your child's mind, watching their money grow is a great way to provide a real-world example of how wealth management works. Consider that a $1,000 investment made in childhood could increase to over $11,000 over five decades, given a five percent average growth rate. With just a $50 per month contribution at the same growth rate, that money would grow up to more than $130,000... or more than $260,000 with a $100 per month contribution. Setting aside money each month teaches your child about the importance of saving and helps establish healthy financial habits.
Keep in mind that if your child is a minor, you may need to set up a custodial or guardian IRA. The maximum contribution for 2017 is $5,500; your child can make contributions as long as they've earned income from a job during the year. Ideally, your child will receive a W-2 form for this work, but if not, keep meticulous records that include:
- The type of work
- When work was completed
- Who the child worked for
- Amount paid to child
As a parent or guardian, helping your child plan for their future through an IRA is a great way to get them started down the road to financial security.