Have you considered opening an individual retirement account for your kids? In the following article, learn about the benefits of starting an IRA for your children, which type of IRA is preferable for young savers, how to open an account, and important rules to follow. Read on to find out more. 

Can Children Have Their Own IRA? 

The short answer is yes! Kids can absolutely have their own individual retirement account. In fact, opening an IRA for your children is a great way to take advantage of compound interest, a wonderful principle in which invested money earns more money over longer periods of time. Starting an IRA for children when they are very young gives them the opportunity to grow a sizable nest egg for retirement later in life. 

Anyone, including children, can open an IRA provided they have earned income, which is defined by the IRS as “all the taxable income and wages from working as either an employee or from running or owning a business.” Basically, if your child earns income, then he or she can have an IRA. Let’s take a quick look at the two types of IRAs you may consider for your child. 

Which IRA Is Preferable for Children? 

Two types of IRAs available for children are traditional and Roth IRAs.

The most important difference between a traditional IRA and a Roth IRA is when you pay taxes on the money you contribute to the plan.

With a traditional IRA, you pay taxes when you withdraw the money at retirement at your then-applicable tax rate. Both the funds you contribute and their earnings are considered pre-tax with a traditional IRA.

With a Roth IRA, you pay taxes when you contribute funds to the account, so both the contributions and their earnings are considered after-tax funds.

The money in both a traditional IRA and a Roth IRA grows tax-free, but the benefit of a Roth IRA is not having to pay taxes on it when it comes time to retire, especially once your children enter a higher tax bracket as senior adults. 

We recommend choosing a Roth IRA for your children. 

Opening a Roth IRA for your child comes with some parameters, which we will explore in the next section. 

Quick Facts About Roth IRAs for Kids

• Roth IRAs for children are essentially the same as Roth IRAs for adults. The main difference is that a parent or other adult, the custodian, must open and manage the investments into the Roth IRA on behalf of the child; hence, these accounts are called custodial Roth IRAs. When the child turns 18, the management of the account is turned over to them. 
• There are no age restrictions regarding when children can contribute earnings to a Roth IRA; they simply need to earn their own income. Even babies and toddlers can technically contribute earnings to a Roth IRA if they model or act, for example. The money earned by children must be real work from a W-2 job or self-employment. 
• You will need to adhere to the Roth IRA contribution limit, which is $6,500 for 2023 (or $7,500 if age 50 and older) or the total amount of earned income for the year, whichever is less. 
• Certain types of income do not qualify for Roth IRA contributions, including rental income or income from property maintenance; interest income; pension or annuity income; stock dividends and capital gains; children’s allowance money; money given as a cash gift
• Parents or other adults can make contributions into a child’s Roth IRA. These gift contributions are not to exceed the child’s earned income for the year. For example, if your child makes $3,000 selling baked goods throughout the year, you could contribute as much as $3,000 as a matching contribution into his or her Roth IRA. 
• Roth IRAs offer flexibility when it comes to withdrawing funds. Provided the account has been open for at least five years, contributions may be withdrawn for eligible expenses. Education expenses, including tuition and fees, books and supplies, and room and board will incur no early withdrawal penalty. Up to $10,000 used for a down payment on a house or closing costs are also acceptable uses of IRA funds without a withdrawal penalty. Finally, the owner of an IRA may withdraw funds for an emergency, but in this case the withdrawals are subject to a 10% early withdrawal fee plus taxes on earnings. 

Opening a Roth IRA account for your child is an easy and straightforward process. If you are ready to do so, find a brokerage that offers Roth IRAs and fill out an application. You will need to provide personal information for both you (as the custodian) and your child (the beneficiary), including Social Security numbers, a form of government-issued photo identification, such as your driver’s license, and bank routing and account numbers. The process can take fifteen minutes or less. 

Getting started with a Roth IRA for your child, no matter what their age, is a financially smart move. In addition to teaching them financial literacy and stewardship, you help them take advantage of compound interest from an early age. Imagine what the return on their investment will be when they reach retirement age!

The experts at Honest Buck are here to help you make the best financial decisions for your Early Childhood Education business and for your family. Get in touch with us to learn more about retirement savings, Roth IRAs, your personal tax strategy, and more. Contact us today!