IRAs for kids are a great way to teach children about investing and the power of compounding.
The biggest mistake I’ve made investing is a mistake almost all of us have made. The mistake is not picking the wrong investment. It’s not buying or selling at the “wrong” time. And it’s not even failing to max out a 401k or IRA.
The mistake is not investing at a young age.
By investing early, you can take full advantage of compounding. Over a lifetime, your wealth should far exceed the amount of your contributions, as this chart from H&R Block demonstrates:
With a Roth IRA for a teenager with some income, they can really get a great start on investing. That’s what we are doing with our children, so I wanted to share some of the things I’ve learned about IRAs for kids.
Rules for IRAs for Kids
The rules and requirements for an IRA for a child are no different than for adults. The contribution limits are the same, currently $5,000 for 2012 and $5,500 for 2013, or the amount of your child’s earned income, whichever is less. And that’s the key. Your child has to have earned income to open or contribute to an IRA.
If a minor does have earned income, then they can open an IRA. The account, however, will need to be opened by a guardian. In the industry they call these types of accounts “custodial” accounts for minors. As an example, Vanguard describes this type of an account as follows: “Establish an account in a minor’s name, administered by an adult custodian, where the investment amount is provided by the minor.”
Where to Open an IRA for a Minor
Virtually all major mutual fund companies and discount brokers offer custodial accounts. The primary considerations here are cost and investment options. If you plan to invest in a single mutual fund, opening an account with the mutual fund company is a great option.
On the other hand, if you plan to invest in ETFs, individual stocks or bonds, an online discount broker is a smart choice. My personal favorite is Scottrade (read my Scottrade review here), but there are many really good discount brokers to choose from.
Roth or Traditional
In most cases, a Roth IRA is a great option. Most children don’t make enough money to incur much if any tax liability. For example, our daughter this year will make about $1,000. According to the current federal tax brackets, her federal tax liability will be just 10%. While predicting future tax rates is impossible, a 10% tax rate is likely much lower than what most children will pay during retirement.
Of course, like any tax issue, you’ll need to make the best assessment you can. But for our children, a Roth IRA is the choice we’ve made.
Funding the IRA
As noted above, the amount you can contributed is limited to your child’s earned income, subject to the IRA contribution limit. In our case, our daughter has saved a portion of her paycheck in an online savings account at ING Direct. To help her get started, we then plan to add to what she has saved so she can invest the maximum amount allowed in her Roth IRA.
Investing for Your Child
For most, simply investing on a low cost diversified index fund will be a great option. For us, I plan to invest in individual stocks. Berkshire Hathaway is high on my list. But what’s really important to me is teaching our children about investing. Part of the lesson is learning how important it is to begin early. But it’s also important to teach them the basics of the stock market. And investing in individual stocks is a great way to learn.
With discount brokers, it’s easy to open an account for your child and buy stock for little money. In our case, I’ll likely open the account with Scottrade, which is where I maintain my SEP IRA. For just $7 a trade, we can invest ROTH IRA funds in a stock like Berkshire Hathaway in a matter of seconds. Again, individual stocks aren’t for everybody. The important thing is to invest. But if you do choose stocks, it’s very simple with brokers like Scottrade.