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:
A teenager with some income can really get a good start with a Roth IRA. That’s what we’re doing with our children, so I wanted to share some of the things I’ve learned about IRAs for kids.
Table of Contents:
The Power of Starting Early
The above chart shows just how powerful investing at a young age can be. To look at this another way, imagine turning $3,000 into $50 million. In his article “How time can turn $3,000 into $50 million,” my good friend Paul Merriman demonstrates the remarkable power of compounding.
As Paul explains, investing just $3,000 for a young child can actually net them $50 million in their lifetime. Part of this magic comes from investing in an asset class with a high return. But another significant aspect is investing in a Roth IRA once your child has earned income.
Rules for Roth IRAs for Minors
The rules and requirements for an IRA for a child are no different than for adults. The contribution limits are the same, currently $5,500 for both in 2017, 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. However, a guardian will need to actually open the account. 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.”
Here’s a summary of these rules:
- Child must be under the age of 18
- Child must have employment income
- The income can come from babysitting, mowing lawns, or other self-employment.
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. Here are several good options:
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%. After factoring in the standard deduction, she won’t pay any income tax.
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 contribute 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. 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 in 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.
Another option is a low cost target date retirement fund. Vanguard offers some great options. In fact, they just introduced a Target Date Retirement Fund 2065! Hard to believe, but that just may be perfect for a Roth IRA for a child.