The Roth IRA is one of the most powerful retirement tools available, giving you the benefits of tax-free growth and tax-free withdrawals.
It’s also an incredibly flexible tool, with possible uses ranging from holding your emergency fund, to serving as a down payment on your first house, and even paying college tuition.
In fact, one of the most interesting ways to use a Roth IRA is as a launchpad for your child’s financial independence.
That’s right! If your child has earned income, whether it’s from babysitting to working at the local grocery store, you can open a Roth IRA together and start contributing some of that money now. It’s a fantastic way to give him or her a financial head start while also providing an opportunity for the two of you to work together and learn some valuable lessons.
In this post we’ll explore why you should consider opening a Roth IRA for your child and how to do it.
Four Reasons to Open a Roth IRA for Your Child
1. Head Start on Financial Independence
You’ve probably already heard all about the wonders of compound interest and really don’t need another lecture. But basically the idea is that every extra year your money is allowed to grow results in an exponential increase, making it incredibly valuable to start investing early.
For example, a 40-year-old investing $5,500 per year (the limit for a Roth IRA) with an 8% return will have $271,826 at age 60. But a 30-year-old doing the exact same thing will have $672,902. Just 10 extra years results in almost three times as much money!
Now take that same concept and assume that you started at age 15 instead. Care to guess what that $5,500 contribution turns into by age 60, after 45 years?
$2.3 million. That’s a lot of money!
Or you could instead look at it like your child would have $672,902 at age 45 instead of age 60. Either way, it’s a huge head start toward financial independence.
One of the great things about a Roth IRA is that the money isn’t limited to retirement.
You’re allowed to withdraw up to the amount you’ve contributed at any time without tax or penalty, which means it’s available for travel, education, starting a business, or any other opportunity your child wants to pursue.
And even beyond that, there are certain ways to access a Roth IRA early without penalty, such as buying a house or paying school tuition.
The bottom line is that Roth IRA money isn’t locked away forever. It’s a flexible account that can provide for almost anything your child wants to do.
3. Tax Benefits
Right now, your child is likely in one of the lowest tax brackets she will ever experience. In fact, it’s very possible that she won’t owe any taxes at all.
Which makes it the perfect time to take advantage of the special tax breaks a Roth IRA offers. The lack of a current-year income deduction isn’t really an issue, and with the tax-free growth and tax-free withdrawals a Roth IRA provides, there’s a decent chance that the money will never be taxed at all!
4. Learn Investing Together
To me, this is one of the coolest potential benefits.
Your child’s Roth IRA is a perfect opportunity for you two to learn about investing together. There’s a lot of time before he or she will need the money, so you can experiment without feeling like a mistake is the end of the world.
You can learn how to make contributions, watch the account value rise and fall with the stock market, choose your investment mix, try out different strategies, and talk about what’s going on the whole way through.
Both of you will learn a ton, you’ll have something to bond over, and you can set up your child for a lifetime where investing is the norm instead of some weird thing only rich people do.
How to Open a Roth IRA for Your Child
1. Meet the Requirements
There are two main requirements your child has to meet in order to have a Roth IRA.
First, in most states the child has to be under the age of 18. Actually, they can have a Roth IRA at any age, it’s just that once they’re 18 it will be theirs and theirs alone. You as the parent won’t have any control over it.
Second, your child has to have earned income. You can refer to this publication from the IRS to determine what counts, but generally any income earned from a job is sufficient. Just make sure to document it in case the IRS wants to double-check.
2. Open a Custodial IRA
A custodial IRA is a special type of IRA where your child owns the account but you have control over it. The money must be used for the benefit of your child and your child typically takes over control at age 18.
Most major brokerages and investment companies offer these, so you should be able to open it wherever you have your own investment accounts.
For 2016, your child can contribute up to $5,500, or his or her total earned income, whichever is less.
Keep in mind that even though your child has to have earned income in order to contribute, it doesn’t actually have to be his money that’s contributed. One interesting idea is to implement a matching program, much like a 401(k), where you match your child’s contribution dollar for dollar. That allows him to have a stake in the account while still having some money left over for himself.
This is where the fun really starts!
Involve your child in the process of learning the basics of investing and setting up a plan. Choose the investments together, track your progress, and experiment along the way.
The goal here is more to learn about investing than it is to maximize returns. That hands-on experience will prepare your child well for the time in her life when investing becomes much more serious.
Experience Is the Best Teacher
One of the best gifts you can give your children is a solid financial foundation. The more comfortable they are with managing money, the more prepared they’ll be to take advantage of everything life has to offer.
Opening a Roth IRA and managing it together is a fantastic way to build this foundation. They’ll not only get a head start on savings, but they’ll get hands-on experience and learn some valuable skills that will serve them well as an adult.
- Four Ways to Use a Roth IRA That Have Nothing to Do With Retirement
- Building a Good Personal Finance Mindset in Your Children
- Retirement Investing 101: The Basics of an IRA
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.