Some young people open individual retirement accounts (IRAs) as soon as they start getting a regular paycheck. But actually, they would have benefitted greatly from starting much younger. Children are in the best position to take full advantage of the power of time and compounding offered by a tax-advantaged savings plan.
Your child, regardless of age, can contribute to an IRA provided they have earned income, defined by the IRS as “all the taxable income and wages from working either as an employee or from running or owning a business.”
Below, we’ll take a look at two types of IRAs for children, the benefits these tax-advantaged investment vehicles offer, and how to open and make contributions to an IRA for kids.
Key Takeaways
- While both traditional and Roth IRAs are options, the Roth variety particularly benefits those who expect to be in a higher tax bracket later in life.
- Children can contribute to an IRA provided they have earned income.
- A child’s IRA must be set up as a custodial account managed by a parent or other adult.
Types of IRAs for Kids
There are two types of IRA, and either is suitable for children:
- With a traditional IRA, the money that is not taxed when it is paid in. The taxes are paid as the money is withdrawn, normally after the accountholder retires. Both the contributions and the earnings they accrue are taxable as income.
- With a Roth IRA, the income taxes owed are paid in the year the money is paid into the account. The funds—both the contributions and the earnings—are considered after-tax money.
Either way, the money grows tax-free as long as it’s left in the account. The benefit of a Roth account to a child is that the account will grow for decades before it is needed. Even then, there are no required minimum distributions (RMDs) on Roth money.
Of course, the rules may change in the next 40 or 50 years, but that’s where they are now.
Even if you claim your child as a dependent, the child may be required to file an income tax return if their gross income exceeds a certain amount set by the IRS. If your child earns less than this amount, they are likely to be in the 0% income tax bracket and won’t benefit from the up-front tax deduction associated with traditional IRAs.
Advantages of Roth IRAs for Kids
Because most kids don’t earn enough money to benefit from the up-front tax deduction associated with a traditional IRA, it makes sense to focus on Roth IRAs.
In general, the Roth IRA is the IRA of choice for minors who have limited income now. By the same logic, it’s often recommended for adults who expect to be in a higher tax bracket in the future.
“If a child keeps [a Roth] until age 59½ (under today’s rules), any withdrawal will be tax-free. In retirement, they would likely be in a much higher bracket, so would effectively be keeping more of their money,” says Allan Katz, president of the Comprehensive Wealth Management Group in Staten Island, New York.
Even if a child wanted to use the funds earlier than that, the account would be advantageous. Roth IRAs are tailor-made for people whose tax bracket is likely to be higher when they need to take the money out, as opposed to when they’re putting it in.
How to Open an IRA for a Child
You may see brokers trumpeting “Roth IRAs for Kids,” but there’s nothing special in the way a child’s IRA works, at least as far as the IRS is concerned.
The opening amount to invest may be less than the usual minimum on these accounts. Otherwise, the main difference IRAs for minors are custodial or guardian accounts.
Banks, brokers, and investment companies all offer IRAs to their customers, and all are legally required to to make them custodial or guardian accounts if the accountholder is a minor. That means under age 18 in most states but others set it at 19 or 21.
As the custodian, you control the assets in the IRA, making all investment decisions until your child reaches majority age and takes charge of the account.
The IRA is opened in your child’s name and Social Security number.
Not all financial institutions do custodial IRAs. Firms that currently open accounts for minors include the following:
How to Fund a Child’s IRA
Children of any age can contribute to an IRA as long as they have earned income, whether it’s from lifeguarding or a fledgling business of their own.
For 2023, the maximum your child can contribute to an IRA (either traditional or Roth) is the lesser of $6,500 or their taxable earnings for the year. This amount jumps to $7,000 in 2024.
This means that a child who earns $3,000 this year could contribute up to $3,000 to an IRA. A child who earns $10,000 in 2024 could contribute $7,000, the maximum. A child who has no earnings cannot contribute at all.
Your Child Must Earn Income
The IRS dictates not only how much money you can deposit in a Roth IRA but also the type of money that you can deposit. Basically, you can contribute only income you earn to a Roth IRA. This means that your child must have earned income during the year for which a contribution is made.
Ideally, your child will receive a W-2 or Form 1099 for work performed. But of course, that usually doesn’t happen with endeavors like babysitting, yard work, dog-walking, and other common jobs for kids. So it is a good idea to keep receipts or records. These should include the following:
- The type of work
- When the work was done
- For whom the work was done
- How much the child was paid
Income that Counts and Doesn’t Count
So what income is acceptable and what isn’t? The money can’t be an allowance (even if the child does chores for it) or a cash gift given directly to the child. Still, although allowances are not allowed, you may be able to pay your child for work done around the house, provided it is legitimate work and the pay is at the going market rate. (You can’t pay $1,000 for a night of babysitting, for example.)
It helps if the child does similar work for outsiders—doesn’t just mow the family’s lawn, for example, but the lawns of others in the neighborhood. Or, if you have your own business, you can pay your child to do age-appropriate tasks for reasonable wages.
General Rules for IRA Income
There are some types of income that are not eligible for IRA contributions by people of any age. The list includes:
- Rental income or other profits from property maintenance
- Interest income
- Pension or annuity income
- Stock dividends and capital gains
- Passive income earned from a partnership in which you do not provide substantial services
For individuals working for an employer, eligible compensation to fund a Roth IRA includes wages, salaries, commissions, bonuses, and other amounts paid to the individual for the services that they perform.
Basically, it’s any amount shown in Box 1 of the individual’s Form W-2.
For a self-employed individual or a partner or member of a pass-through business, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.
Money related to divorce, such as alimony, child support, or in a settlement, can also be contributed if it is related to taxable alimony received from a divorce settlement executed prior to Dec. 31, 2018.
Can Others Contribute to a Child’s Roth IRA?
Yes. Direct contributions to a child’s Roth IRA can be a gift from you or someone else. And they truly are gifts that keep on giving. Since Roth IRAs can be invested in almost any sort of asset, they are likely to perform much better than a good old savings bond or bank account.
Many parents choose to match their child’s earnings and make the IRA contribution themselves. For example, if your child earns $3,000 at a summer job, you can let them spend their money as they wish and make the $3,000 IRA contribution with your own money. You might also offer to contribute a percentage of what your child earns, such as 50%. (Your child earns $3,000 and you contribute $1,500.)
Remember to consider gift tax rules. The contributions you make to a Roth IRA for your kid will count against the limit on tax-free gifts you can make to one person, which is $17,000 for 2023.
Whatever approach you decide to take, the IRS doesn’t care who makes the contribution as long as it does not exceed your child’s earned income for the year. If Sam made $2,000 from their lemonade stand one summer, $2,000 is all you or Sam can invest in the IRA. Since the contribution is made to your child’s IRA, your child—not you—receives any tax deduction.
Benefits of IRAs for Kids
Along with the obvious motivations of building a nest egg, IRAs offer other benefits for kids, both in the present and in the future.
Financial Literacy
Opening an IRA for your child provides them not only a head start on saving for retirement, but also valuable financial lessons. Even a small IRA can be an introduction to investing and a platform to teach your child about money and the relationship between earning, saving, and spending. It can also teach them the lesson of compounding, which works best if it has the longest amount of time to work.
For example, a single $1,000 IRA contribution made at age 10, for example, could grow to $11,467 over 50 years, assuming a conservative 5% average annual growth rate. Contribute $50 each month, and the account could grow to $137,076 (with the initial $1,000 contribution and the same hypothetical growth rate of 5%). Or you can double the contribution to $100 each month, and the account could reach $262,685.
Tangible Uses
IRAs are designed for retirement spending but a child may be able to tap into the account well before then for important expenses—particularly if it is a Roth account.
Roth accounts allow withdrawals of contributions (not the accrued profits), provided the account is at least five years old.
Regular IRAs have tougher rules but they also allow penalty-free withdrawals in special circumstances. Such needs could include the following:
- Education Expenses: The account holder can withdraw money for college, but will owe taxes on the earnings that are withdrawn. However, there is no 10% early withdrawal penalty if the money is used for qualified education expenses, such as tuition, fees, books, supplies, equipment, and most room and board charges.
- Buying a House: The account holder can withdraw funds to buy a first home at any age. The money must be used as a down payment or for closing costs. The withdrawal is limited to $10,000. Early withdrawals for a home purchase are penalty-free and tax-free.
- For Emergencies: The owner of a Roth IRA can withdraw money in an emergency. But the withdrawal will be subject to taxes on the earnings, plus a 10% early withdrawal fee.
Still, it’s worth stressing that this is supposed to be a retirement fund. “We suggest keeping these funds intact if at all possible rather than removing them for a first home purchase, for example,” says Elyse Foster, certified financial planner and principal of Harbor Wealth Management in Boulder, Colorado.
Can I Open an IRA Account for My Child?
Yes. Many banks, brokerages, and other financial institutions offer IRAs to their customers, but not all offer IRAs for children. The difference is that a child’s IRA is a custodial account managed by a parent until the child reaches adulthood.
Any child, regardless of age, can contribute to an IRA provided they have earned income, defined by the IRS as “all the taxable income and wages from working either as an employee or from running or owning a business.”
The rules are flexible enough to count income from babysitting and lawn mowing, but if there’s no W-2 involved, keep records of this kind of work
How Much Can I Put in My Child’s IRA?
IRA maximum contributions are the same for all ages. There’s an annual limit of $6,500 per child, per year for 2023. This increases to $7,000 in 2024.
How Does a Custodial IRA Work?
A custodial IRA is an individual retirement account that a custodian (typically a parent) manages for a minor. The assets are controlled by the custodian until the child reaches adulthood. The age is 18 in most states.
The Bottom Line
Young people have a tremendous advantage when it comes to investing—namely, time. “At their young age, compounding kicks into high gear due to the long-time horizon,” says chartered financial analyst Dan Stewart, president and CIO of Revere Asset Management in Dallas.
Stewart tends to favor Roth IRAs, since “usually they will be in a low or even zero tax bracket.” Even relatively small IRA contributions can grow significantly over time, he notes. If you make a single, one-time $6,500 contribution to a child’s Roth IRA when they are 15, for example, that can grow to more than $191,471 of tax-free money by the time they hit 65, assuming a 7% annual return. If they waited until they were 35 to make that first contribution, they would need to invest about $25,153 to reach the same amount.
In addition to the cold hard cash growing in an IRA account, your child will have the added benefit of developing healthy financial habits: Many financial experts and educators believe that the earlier children begin learning about money, the better their chances for financial stability in the future.