Have you wondered about opening a child IRA account for your child? Many people aren’t sure whether the idea is practical or legal. In fact, if you want to teach your kids the value of saving and give them a considerable head start on building a retirement account, opening a custodial IRA makes good sense. There are several steps to the process.
First, research the topic, so you know the mechanics of creating a custodial IRA. Then, take the chance to explain to your children nine and older how interest works. Finally, use a compounding calculator online to demonstrate the concept to them and develop a few savings scenarios based on differing contribution amounts.
Finally, work through an example calculation on your own (see below) to reinforce the basic math behind long-term savings. Opening an IRA in a child’s name is an excellent way to teach children and to begin putting money aside for their future.
Exploring the Topic of Child IRAs
Find out about the general rules for custodial IRAs. For example, it’s worth noting that the Roth IRA is the better choice in nearly every situation, compared to a traditional version, for children. Other important facts to know about IRAs for kids include the following:
- The limit for contributions is currently $6,000 per year
- Neither you, your child, nor anyone else can contribute amounts to the IRA that exceed the child’s earned income for the year of the contribution.
- It’s best to document the child’s earned income by evidence like a W-2 or a 1099 form.
- You cannot include allowances or gifts as part of the definition of “earned income,” even if you pay your child for doing household chores.
However, there are some exceptions to this rule if you hire your child to do small jobs in a family business or to do contracted work directly for you, and you pay the going rate for the work.
- You must be the custodian of the account until the child reaches the age of 18, 19, or 21, depending on the state laws where you live. After that, the child takes complete control of the account.
- There’s usually no sense in opening a custodial IRA for a child under the age of 10.
- If your child has earned income, and you have opened a custodial IRA for them, anyone can put money into the account up to the child’s earned income, or $6,000, whichever is the lower amount.
That means if your daughter earns $5,500 from babysitting, you can choose to let her keep the money. Then, you could put $5,500 into the IRA for her. Many parents use this system to encourage their kids to earn money of their own and learn about the value of retirement savings.
The Incredible Power of Compounding
One of the many benefits of opening a custodial IRA for a child is that it gives you the chance to teach them how to earn money and save it responsibly. Plus, the account has the opportunity to grow for many years, often more than 50, before the child reaches retirement age.
The impact of a 50-year timeline on an interest-earning account is significant. Consider an example using a compound interest calculator. For our hypothetical but very realistic example, we’ll assume that you open a custodial IRA for your daughter, Jill, when she is 10 years old and that she earns $5,000 babysitting and mowing neighborhood lawns every year until she goes to college after turning 19.
Jill’s Contributions From College Until Age 65
Each summer during college, Jill earns enough money from part-time jobs that she is able to continue the annual IRA contributions in the same amount, $5,000. Note that she could contribute $6,000 per year if she wanted to but chooses to keep the $5,000 amount.
After college, Jill works until age 65 at a full-time job, adding $5,000 each year to her Roth IRA. Using the calculator, we figure that she has made 56 annual contributions, from age 10 until age 65, to the account and that the account had an average yearly interest rate of five percent.
Using the Calculator
Input the data above into the compound interest calculator and see how much Jill has in her Roth IRA at age 60. Assume zero opening balance, annual interest of 5 percent, annual contributions, and 56 annual payments.
Jill has $1,436,741 in the account at retirement, of which $1,156,741 is interest on the cash contributions of $280,000.