Give your kids a head start

Did you know that the babysitting money your child is earning could help fund their retirement? I know that many of us with school-aged children are more concerned with paying for their college education than their retirement at this point. But contributions at a young age can provide a huge advantage in setting your child up for a lifetime of financial security.

Any minor with earned income is able to contribute to a custodial IRA, an IRA opened by a parent or other adult for the child. The adult remains custodian of the account until the minor reaches the age of majority (either 18 or 21) when the child takes control of the account. I recently opened a custodial Roth IRA for my 14-year-old son and it was a simple and straightforward process.

Since most minors do not have significant income, opening a Roth IRA instead of a traditional IRA for them is the best choice. With a Roth IRA, contributions are not tax-deductible, but growth of investments is tax free, as are withdrawals of earnings after the age of 59 ½ (as long as the account holder has had a Roth IRA for 5 years). With a traditional IRA, contributions are tax-deductible and withdrawals are taxed at the account holder’s income tax rate at the time of withdrawal. Since minors are in a much lower tax bracket now, it makes sense for them to use a Roth IRA, so they don’t have to pay taxes on earnings withdrawals when they are older and in a higher tax bracket. Further, there are no required minimum distributions from a Roth IRA later in life. (More on the importance of that in a future blog post!)

One of the tremendous benefits of opening an IRA for your minor child is the gift of time. I ran some numbers on the Bankrate Roth IRA calculator and found that a person who started contributing $1,200 a year at the age of 14 would have more than double the amount of savings at age 65 ($523,183) than a person who started contributing at the age of 25 the same amount under the same conditions ($239,562).

If you have a hard time getting your child to buy in to retirement savings, run these numbers on a calculator for them and it might give them a little more incentive! Further, if a child gets a head start saving now, they may not have to contribute as much of their income to their retirement accounts during times in their lives when they experience more financial pressure, such as when they have children of their own and the many expenses that go with that.

If getting your child to contribute to a retirement account is a hard sell, think about contributing small amounts to their account yourself. Anyone can contribute to the child’s IRA, as long as contributions do not exceed the child’s income for that year (and the IRA contribution limit - $7,000 for 2024). You could have your child contribute some of their income and you could match it with a contribution, as long as the total contributions do not exceed their earned income for the year. For example, if your child earns $1,000 in a year, they could contribute $500 and you could contribute $500 to their IRA. When documenting their income, consult with a tax advisor about whether or not your child should file a tax return.[i] If your child is not filing a tax return, keep records of their earnings in the years IRA contributions are made.

While the goal of these accounts is obviously to save for retirement, contributions (though not earnings[ii]) to a Roth IRA can be withdrawn at any time and at any age tax and penalty free, in case your child has a financial emergency. Further, your child, even if under the age of 59 ½, may withdraw up to $10,000 from their Roth IRA tax and penalty free for the first-time purchase of a home, as long as they have had a Roth IRA for at least 5 years. Other exceptions to the 59 ½ year rule exist for Roth distributions, such as paying for higher education expenses.[iii]

While our children’s retirement may not be at the top of our concerns in our day-to-day life right now, getting your child set up with a custodial Roth IRA at a young age can lay the groundwork for a secure financial future for them in the years ahead.

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[i] Generally, dependent minors are not required to file a tax return if they have earned income below $13,850 (in 2023). However, if a minor earning less than that is receiving W-2 wages and has taxes withheld from their paycheck, they may want to file a tax return to receive a tax refund, if due. Also, anyone earning more than $400 in self-employment income (i.e. babysitting, mowing neighbors’ lawns, etc.) should file a tax return to pay self-employment taxes.

[ii] Withdrawal of earnings before the age of 59 ½ are subject to income tax and an additional 10% penalty tax, unless they qualify for one of the exceptions.

[iii] While you may withdraw earnings without penalty to pay for higher education expenses, earnings will be subject to income tax. Consult with your tax advisor about the rules related to such distributions.