You may have heard about all the advantages of saving in a Roth IRA. You may have even thought to yourself, "I wish I started one earlier." While you may think you have 'missed out' you might be able to help your own children take advantage of the benefits now for their future. There are a few guidelines to follow but you can open an IRA for your child under the age of 18. It is a great way to give your kids a head start on savings and investing.
First, your child must have earned income to contribute to a Roth IRA, just like you do. Earned income is money made from working and does not include an allowance or birthday money from grandma. Earned income could include any money they make from activities such as a part-time job, babysitting or cutting the neighbor's grass. But for these dollars to count as earned income it must be claimed as such with the IRS and your child may be subject to the 15.3% self-employment tax.
If you own a business, you can hire your child and pay them a reasonable wage for the work they do. Unfortunately, putting a very young child on payroll, such as a 6-year-old for a $6,000 salary will not be "reasonable" to the IRS. If you place your child on payroll, they must be a legitimate employee. A good rule of thumb is to not pay your child more than you would pay another employee to do the same work.
The same contribution and income limits that apply to adults, apply to children. For 2020 (for a prior year contribution) and 2021, the maximum contribution for an individual under the age of 50 is 100% of earnings up to $6,000. If your child earns $3,000 for the year, the maximum annual contribution is $3,000. If they earn $8,000, the maximum is $6,000. You can make the contribution on their behalf as long as it does not exceed their income, or the maximum, for the tax year.
The same income limits also apply but may not be an issue. A single person can contribute the maximum if their income is below $124,000 in 2020 or $125,000 in 2021. The deadline to make a Roth contribution is the tax filing deadline so there is still time to make a 2020 contribution before taxes are due April 15, 2021.
Although, the Roth IRA is for the benefit of your child, they will not be able to open their own account without you. You will need to serve as the custodian of the account until they reach the age of majority in your state (age 18 or 21). You will be able to make investment decisions until they become of age then Roth IRA will be transferred to a new account in their name only and they gain full control.
We have all heard the tales about starting early and how much easier retirement savings is when you do because of compounding interest and growth, but what does that look like for your child? Let's assume at 15 they start a lucrative lawn mowing business and choose to invest $1,000 with a 7% rate of return; they would have almost $30,000 at 65. If they wait until 25, to invest $1,000 with a 7% annual rate of return, their account will be worth approximately $15,000 when they are 65 - that's half the value!
This money will grow tax-deferred and, because Roth IRA contributions are made with after-tax dollars, withdrawals will be tax-free for your child after their age 59 ½. Educating our children about the importance of saving early and encouraging them to do so, provides great rewards for their future.