When should your kids get an IRA?

I had no idea what an IRA was as a kid.  The furthest thing from my mind was retirement.  I didn’t make any earned income until I turned 16 anyway and I wanted to use that money for going to the movies, tennis racquets, and cheeseburgers.

I grew up in a middle-income household and my parents didn’t teach me about the benefits of retirement accounts. It wouldn’t have mattered much anyway since they didn’t have any extra cash to throw in a kid’s retirement account.

As a parent, opening an IRA with your child could be one of the smartest financial decisions you make. With relatively little effort, you are opening the door to a whole new world of financial discussion and opportunity for learning.

There will be new vocabulary, new ideas, and new opportunities to teach your children about the inner workings of some very important concepts as they grow older and start to assume control of their own finances.

The process introduces them to economics, the stock market, saving principles, the magic of compound interest and the excitement of watching their little hard earned dollars continue to earn more dollars for them over the months and years.

 

When should they get one?

The optimal time for your child to get an IRA is when they first start making earned income. A lot of teenagers get a part time job when they turn 16. Some kids have opportunities to garner earned income even earlier. If your child gets a W2, every dollar up to $5500 can be deposited in an IRA account.

As a high-income earner, there might be some leeway in your financial situation to help your child along.  If you were going to give your child some money anyway in the form of an allowance, you could have him use his wages for personal expenses and then deposit the equivalent of the allowance money in his IRA. It’s all the same in the IRS’s eyes as long as your child has the earned income.

What are some options?

If you were planning on giving your child money in the form of a 529, contributing some of that into an IRA could be advantageous. If your child can earn the full amount ($5500) from an outside job, parents could contribute the full $5500 into the IRA. This gives your kid some different options when it comes time to make decisions about funding higher education.

If you’re worried about overfunding a 529, you could divert some funds to a custodial IRA. That may make more sense and leave more money for your child in later years. Of course, I wouldn’t recommend this if it sacrifices your own retirement goals.

The disadvantage is the parent doesn’t have control of this type of account once the child reaches the age of majority.  Regardless of your intentions, he can use the money as he pleases, including withdrawing the whole amount.

 

What type should they get?

As a minor, your child can only get a custodial (or minor) IRA account until she reaches the age of majority in your state (18 years old in every state but Mississippi and Washington D.C. at 21 and Alabama at 19). Now the question is which type of custodial IRA?

 

 Custodial Roth IRA or Custodial Traditional IRA

The custodial Roth IRA operates like any other Roth. Children and parents can place the money in the account after tax. Then, all the funds grow tax-free. The custodial traditional IRA operates like any other traditional, the money goes in tax-deferred as long as the child’s income is below the phase-outs. ($62,000 to $72,000) Read more about deductions here and here.

Using the Roth option, none of the income is taxed up to $6350 (individual standard deduction) and the child is a dependent. Most kids don’t make over this amount, so the Roth is probably going to be your best bet.

If the child has investment income outside the IRA (interest, dividends, capital gains) then the first $1050 is tax-free. The second $1050 is taxed at the child’s tax rate. Anything above that is taxed at the parent’s highest tax bracket rate. This applies to any child under 19 or under 24 if he is a full-time student and doesn’t supply over half his own support for living on this planet.

Can a custodian IRA help the parents?

If you have your own business, paying your child to perform work at the business can help both of you. Your child isn’t subject to medicare and social security tax up to age 18. Your child isn’t subject to unemployment taxes until age 21. FICA taxes are 15.3% for 2017 and in Texas unemployment tax can be as high at 8.21% on the first $9000. (Check your local state laws for your unemployment tax rate.)  That saves both you and your children a quarter of the child’s pay in taxes.

Even if your child is over those ages, using her for legitimate work at a legitimate market wage will divert parental income (usually taxed at a much higher rate) to the child’s lower tax bracket.

 

Where should they get it?

Several of the top brokers have custodial IRA options.

Charles Schwab: Schwab has a $100 minimum to open the account. You can download the application and check out their information here. I would recommend Schwab first because of the low minimum to open the account. You also get access to their free ETF’s for investing.

TD Ameritrade: Check out their information here. With an account here you get access to their 100+ free ETF’s and they have no minimum to open the account. TD Ameritrade is also a good option and with their 100 free ETF’s you have access to Vanguard ETF’s.

Vanguard: You can download the application here. There is no minimum to open the account but if you want to invest anything you must have at least $1000 to buy the Vanguard Star Funds. Other funds have a $3000 limit. Preferred expense ratios don’t occur until admiral share status. This could make it a more expensive option until a couple years of fully funding the IRA. They waive the $20 annual fee with electronic statements.

Edward Jones: They have an option here. I don’t recommend them in general because they tend to have much higher fees that the other three brokers. The speak about a $40 maintenance fee in their literature.

When should your kids get an IRA?

Usually, there are bonuses available when you deposit larger amounts to these brokers as the parent. If it makes sense for your situation, transferring some of your own assets along with the child’s could land you the bonus.

Remember that you can’t co-mingle the accounts. The child’s IRA must be separate from yours.

I have to say that Schwab makes this the easiest to find information. It took a call to both TD Ameritrade and Vanguard to find out the specifics of the account and what the fees entailed.

 

Will it affect college?

The FAFSA doesn’t factor in tax-deferred retirement accounts when calculating need. This type of account won’t hurt your child when applying for college financial aid.

This is in contrast to a 529 plan that does factor into the expected family contribution when it is owned by the parent or a dependent student. When calculating financial aid need, the net value of the 529 account reduces the amount of financial aid by 5.64%.

Of course, your large income doesn’t help get free college funds, but at least the assets in the child’s name that are in tax-deferred retirement accounts don’t hurt as well.

The child could also use the funds for college. I wouldn’t recommend this, but it is something to consider. Students can use all the principle to fund eligible higher education expenses without tax from a custodial Roth account. The child pays his regular tax rate on earnings, but no 10% penalty. They charge the penalty if the child uses the funds for non-educational expenses.

 

Do they have to use it for retirement only or can they take out the money early?

The custodial IRA transfers to a regular IRA once the child reaches the age of majority. Like any IRA, the child can withdraw the funds for general expenses, but they are taxed and penalized. The only expenses that aren’t penalized are qualified education expenses.

The best strategy is to leave it there until retirement. If the money is needed before 59 1/2, you can use other strategies to reduce taxes and penalties, but that is another article.

 

Are there any drawbacks?

All money transferred into the account is irrevocable. You can’t have it back.  The custodian is to administer the account in the best interest of the beneficiary.

The money is taxed at the regular income rate, plus 10% if the money withdrawn from the child’s account is used to benefit the parent.  On top of that, the IRS could require the parent to repay all previous tax savings.

 

So what are you waiting for? If your kid makes some earned income, you and your child can open an IRA. Even if you just deposit the $100 in the Schwab account, you are starting on a journey to teaching your child about investing and managing her retirement.

Let me know if you have further questions. I just opened my 15-year-olds account last year with Schwab and we have begun the process. 

Tom
Tom is a doctor and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

12 Responses to “When should your kids get an IRA?

  • Some food for thought. We are funding a 529 but I have debated what to do once my son (now 2) starts making some money. It seems like a IRA is the way to go (Roth unless he becomes a child star or fashion model, then we are blowing it all on Smores!).

    I don’t think money given to kids should be seen as something you want back. Still if you were in a precarious financial situation this would be tempting.

    • I totally agree with you DDD about giving money to your kids and not wanting it back. If someone is giving it with that kind of heart where you are resentful for giving it, then you have bigger problems.
      It would be a worse case scenario to take money out of our kids IRAs to fund our own parental expenses but worse things have happened to other families. It’s all calculated risk.

      Tom @ HIP

  • With the time value of money and compounding, the sooner the better when it comes to investing and preparing for the future. The kids may not understand it when they are young but will be very thankful for it as they get older and start learning more. Great post, thanks for sharing.

    • No doubt. That’s a really good point I didn’t bring up.
      Kids tend to think of the here and now but if parents can keep them looking down the road, eventually that compounding interest starts to look very nice to them. Thank you for reading. 🙂

  • As soon as my son starts to earn income I am going to encourage that he sign up for an IRA. I wish I had done this when I was a kiddo. But I guess you live and learn 🙂

    • Thats great MSM. So far I have one down, four to go. Its been great for teaching about investing so far.

      Tom @ HIP

  • So glad to see others talking about this strategy for thier teens! We opened Roth IRAs for both of our kids when they got jobs and so far a great intro to investing and retirement in general. The first kid is 19 now and putting more money than we are into his Roth. Thats a beautiful thing. One of our best moves as parents!!

    If your child has earned income, you should really consider it if you have the money of course.

    • Couldn’t agree more. If you have the funds it’s great for the kids.

      Tom @ HIP

  • Theresa
    1 week ago

    Just getting the account open is extremely helpful. My parents did this for my siblings and I as teenagers, and in addition to the 5k-ish of seed money (nice), it also meant that we were already in the mindset of saving for retirement from that early age and had a convenient vehicle for doing so. When I had a little extra earned income from my college research job, for example, I could contribute a few hundred dollars to the account that was already there and open, whereas I wouldn’t have bothered (and might not have met account minimums) for such a small amount. This went along with many kitchen-table graphs of the wonder of compound interest (both ways). My dad chose well, and I’ve had Vanguard accounts since I was a teen.

    My kids are young and have no earned income yet, but I use this same thought process when they start an allowance at age 5. I take them to our local credit union to open a bank account, and they do all the talking – name, address, Birthday – and handing over their crumpled stacks of bills, or making on-person withdrawals. I want them to be comfortable navigating the financial milieu.

    • That’s a great point about contributing income along the way. Having the account open makes it a path of little resistance for our kids to stock money away for retirement. I’ll have to keep reminding my son about that as he earns more and more income. Thanks for reading.

      Tom @ HIP

  • Dood, el Farbe
    4 days ago

    Another very timely article and something that wasn’t even on our radar! Our oldest will graduate this year and is looking for a “real” (W2) summer job. After reading this post, I showed her Excel plots of what just 2K per year in a Roth over the next 4 summers will become at age 59.5 at average growth of 4, 8, 10 and 11.69%.

    Her eyes popped seeing that 8K turn into hundreds of thousands of dollars.

    Then, without prompting, she said, “Wait. You said I can put only as much as I earn in W2 pay. I want to work because I want money to spend in college. What if I keep my pay and you and Mom give me that amount to put in the Roth?”

    Mom said “maybe, we’ll see”.

    It was also a great preamble to 401(k) discussion and all the kids were listening by then as I mentioned friends who started with me at my first corporate job who felt that “later” was okay to start saving, not even putting enough in to get the full match. I used the same data from the Roth calculation to show how much was lost by starting just 5 years later, and to really drive home why sacrificing early has such a huge impact later.

    Thank you!

    • I’m reading your mind and writing about it! 🙂
      This warms my heart to hear family discussions happening about important financial factors like this. Keep up the great work.

      Tom @ HIP

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