When you think about retirement accounts, you probably picture adults saving for their golden years. But did you know that your child can start saving for retirement too?
Yes, you can actually open an Individual Retirement Account (IRA) for your minor child!
It might sound a bit unusual, but it’s a smart way to give your child a head start on building wealth for the future. Plus, if you have your own business, opening an IRA for your child can help you save money by providing them with a legitimate income source. Let’s break down how it works and what you need to know.
What Is an IRA, and Why Should Your Child Have One?
An IRA is a type of savings account designed specifically for retirement. The main perk is that it offers tax advantages, meaning your money can grow faster than it would in a regular savings account.
But why should your child have an IRA? The answer is simple: time. The earlier you start saving, the more time your money has to grow. Even small contributions made now can turn into a significant nest egg by the time your child reaches retirement age.
Scenario 1: Starting at Age 15
- Contributions: $2,000 per year for 3 years (ages 15-18)
- Total Contributions: $6,000
- Assumed Annual Growth Rate: 7%
- Account Value at Age 65: Over $130,000
Scenario 2: Starting at Age 30
- Contributions: $2,000 per year for 3 years (ages 30-33)
- Total Contributions: $6,000
- Assumed Annual Growth Rate: 7%
- Account Value at Age 65: Approximately $45,000
By starting contributions at age 15, your child’s investment has more time to grow, resulting in an account value of over $130,000 by age 65, compared to only about $45,000 if they start at age 30.
Types of IRAs: Roth IRA vs. Traditional IRA
There are two main types of IRAs: Roth IRA and Traditional IRA.
- Roth IRA: Contributions are made with after-tax dollars, meaning your child won’t get a tax break now, but the money can be withdrawn tax-free in retirement.
- Traditional IRA: Contributions might be tax-deductible, but your child will have to pay taxes when they withdraw the money later in life.
For minors, a Roth IRA is usually the preferred choice because they’re likely in a low tax bracket now, and the tax-free withdrawals in the future can offer a huge benefit.
What Are the Requirements for a Minor to Contribute to an IRA?
Here’s the key point: earned income. Your child must have earned income to contribute to an IRA. This means they need to make money from a job, whether it’s babysitting, mowing lawns, or even acting in commercials.
The amount they can contribute to an IRA is the lesser of their earned income for the year or the annual contribution limit, which for 2024 is $7,000. So, if your child makes $1,000 from a summer job, they can contribute up to $1,000 to their IRA.
It’s also important to note that while you, as a parent, can open and manage the account, the money belongs to your child. Once they reach the age of majority (usually 18 or 21, depending on your state), they gain full control of the account.
Paying Your Child Through Your Business: Creating Legitimate Income for Their IRA
If you’re a business owner, you have a unique opportunity to pay your child for work done in your business, which can create legitimate earned income that qualifies them to contribute to an IRA. This approach helps your child start saving early for retirement and can also offer tax advantages for your business.
- Legitimate Employment: Your child must actually perform work for your business to be paid. This could be anything from helping with administrative tasks, filing, social media management, cleaning, or even marketing activities. The key is that the work they do must be real and appropriate for their age.
- Fair Wages: You should pay your child a fair wage that aligns with what you would pay another employee for the same work. Overpaying could raise red flags with the IRS, so make sure the compensation is reasonable for the job being done.
- Tax Benefits: Wages paid to your child can be a tax-deductible business expense, reducing your taxable income. If your child’s total income is below the standard deduction threshold, they likely won’t owe any federal income taxes, making this a win-win situation.
In short, paying your child through your business is a great way to give them a financial head start while potentially reducing your tax burden. It’s a win-win strategy that benefits both your family and your business.
Example: How It Might Work
Let’s say you own a small business, and you hire your 14-year-old child to help with filing paperwork and managing your social media accounts. You pay them $3,000 for the year, which is a reasonable wage for the work they’ve done.
That $3,000 is now their earned income, allowing them to contribute up to $3,000 to a Roth IRA for the year. As a business owner, you get to deduct that $3,000 from your taxable income, potentially lowering your business’s tax liability.
Important Considerations
- Documentation: Keep thorough records of the work your child performs, including hours worked, tasks completed, and payment records. This documentation is crucial if the IRS ever questions the legitimacy of the employment.
- Age-Appropriate Work: Make sure the work is suitable for your child’s age. The tasks should be reasonable and within their capabilities.
- IRS Rules: Familiarize yourself with the IRS rules on employing family members to ensure compliance. For example, if your business is an LLC or a sole proprietorship, you won’t have to pay Social Security and Medicare taxes on your child’s wages if they are under 18.
How to Set Up an IRA for Your Child
- Find a Custodian: You’ll need to find a financial institution that offers custodial IRAs. Most major brokerages, banks, and credit unions offer this service.
- Open the Account: Once you choose a custodian, you can open the account in your child’s name. You’ll act as the custodian until your child reaches adulthood.
- Fund the Account: Your child’s earned income can be contributed to the IRA. You can even match their earnings if you want, but remember, the total contribution cannot exceed their earned income for the year.
- Choose Investments: Decide how to invest the money. IRAs offer a wide range of investment options, including stocks, bonds, and mutual funds. It’s a good idea to teach your child about investing as you make these decisions.
- Monitor the Account: Keep an eye on the account’s performance and make adjustments as needed. This is also a great opportunity to involve your child and teach them about money management.
Is It Worth It?
Opening an IRA for your minor child might seem like a big step, but it’s one of the best financial gifts you can give them. With just a little bit of earned income, they can start building a secure financial future today.
And who knows? Your child might just grow up to be the next Warren Buffett!
Now that you know the basics, consider talking to a financial advisor to get started. After all, it’s never too early—or too late—to start planning for the future.
