IRAs for Children

You don''t have to be an adult to qualify for an IRA. You just need work-related income. IRAs, particularly Roth IRAs, are a wonderful idea for younger generation family members because your generosity imparts some enduring lessons, including:

  • Giving an IRA to a younger generation family member conveys the importance you place on saving for the future, in this instance, saving for retirement which is many decades away. This is an important lesson that could provide life long benefits for younger generation family members. There is also an entirely selfish reason for contributing to their IRAs. By doing your best to inculcate good financial habits in your children or other youngsters in your life, you will hopefully not have to spend half of your retirement income supporting them.
  • At a minimum, opening an IRA on behalf of a young person provides a chance to teach them a bit about investing and the miracle of compound growth. But more importantly, you will be able to convey to your child, niece, nephew, or grandchild the importance of starting to save for retirement even though it''s many decades away. The young person will also get an early lesson in the power of compounding as the money grows.

Setting up an IRA for a child:

  • There is no minimum age to set up an IRA. If the child is a minor, many, but not all mutual funds, brokers, and banks will allow you to set up a "custodial IRA" also called a "guardian IRA."
  • There''s no requirement that the same dollars that were earned be used to fund the IRA. You can gift the money to the child. (If my teenagers ever volunteer to fund their IRAs out of their job earnings, my wife and I will drop dead on the spot.)
  • The major challenge for setting up IRAs for children, especially young children, is the earned income requirement. The income must be related to work. Investment income doesn''t qualify. That doesn''t necessarily mean that the child has to actually pay tax on the income. Even though the total amount of income may be small enough that an income tax return does not have to be filed, it will still qualify for an IRA contribution. A lot of informal work for pay will qualify, including babysitting, mowing lawns or similar tasks, as well as part-time or summer jobs in high school or college.
  • What about earnings from household chores? The IRS has not yet ruled on this issue. Some tax experts indicate that, so long as the child actually does the chores, this qualifies as earned income. Many others caution against it, so before you set up an IRA funded on the basis of an allowance or payment based on household chores, it''s prudent to check with a tax professional.
  • Roth or traditional IRA? A Roth IRA is almost always preferable to a deductible IRA because a Roth offers a great deal more flexibility when withdrawing money from the account. Another argument for a Roth IRA is that the child''s income is likely to be so small that no taxes are due and, hence, there is no benefit from a tax deductible IRA.

Other considerations.

  • Whichever IRA is established, the child or grandchild will not necessarily have to wait until retirement to make good use of your largess. Subject to some limitations, tax rules permit IRA money to be withdrawn without penalty to help pay for first home purchase. If the money is in a Roth, the child will probably be able to withdraw more of it for a home purchase compared with a traditional IRA.
  • Putting money in a child''s name is usually not advantageous if there''s a chance the family will qualify for college financial aid. But IRAs are not considered in the financial aid applications, so an IRA account should not jeopardize qualification.
  • Keep in mind that money in a child''s IRA belongs to the child. Hopefully, the child will hold onto the money, but there''s always a chance that he or she will do otherwise. Of course, if Junior cashes in the IRA to take a vacation, this might serve as a valuable indicator of how you eventually pass on your estate to him.
  • Finally, once a younger generation family member joins the work force, your generosity can also provide a lasting money lesson. You could offer to help him or her make contributions to a workplace retirement savings plan, like a 401(k) or 403(b) plan. It''s a struggle for people who are starting out in their first real jobs to contribute to these plans at a meaningful level without a little help from the relatives.

Giving money to the younger people in your life that is earmarked for a retirement that is decades away empowers both the kids and you. They''re empowered because you have shown them how to become financially well off. You''re empowered because by raising financially savvy children you no longer have to concerned about passing an inheritance on to them. Thus, once you retire, your primary financial strategy will not be inheritance maximization; rather, it will be spending maximization.