Can I Start an IRA For a Child?

There are IRAs for young entrepreneurs.

You can start an IRA for a child if you meet the two key qualifications. First, the child must have earned income in the tax year you designate the IRA. This can be different from the year you open the IRA. Up though April 15 when taxes are due, you can open an IRA for the previous tax year. Starting January 1, every year, you can open an IRA for that calendar year any time during the year. Just be sure that you open the IRA for the year the child has earned income. Second, you must be the child's parent or legal guardian. Not every bank or brokerage firm will open an IRA for a child. IRA investment choices for a child are the same as for adults. The bank or brokerage usually includes some reporting features that link to your other accounts so the child's IRA is easy for you to manage and fund.

Earned Income is key

Jobs with W-2s are ideal for tracking children's income.

Young children work as models, actors in films, and in television commercials, sometimes earning substantial income. More commonly, they mow lawns, babysit, have paper routes or take a job in the family business. From the government's standpoint, earned income is taxable and the child should file a tax return. Paying children for family chores is a gray area and income could be hard to prove. If a child has a W-2 showing income, the picture is much clearer. For entrepreneurial activities like a custom T-shirt business, the youngster should file taxes and keep records and receipts that show sales and expenses.

Roth IRA or Traditional IRA?

A Roth IRA is best for growth, tax and withdrawal advantages.

With either a Roth or Traditional IRA, the maximum allowed contribution is $5,000 per year provided the child has at least $5,000 in earned income. The amount invested in a traditional IRA is tax deductible, but contributions to a Roth IRA are not deductible. Once the funds are in the Roth IRA account, the earnings and the original amount are free of taxes when withdrawn after age 59½. Given their youth, kids are better off with a Roth IRA as they have a longer time for earnings to accrue. It is possible for a child to own both a Roth and traditional IRA, but the annual total contributed to both cannot exceed $5,000. The parents are in charge until the child is 18 and legally of age.

Paying for college with an IRA

You and your child can both tap IRAs for college.

IRAs have flexibility for funding education. There are only a few types of IRA withdrawals before age 59½ that do not carry a 10 percent penalty. Fortunately, withdrawals for higher education expenses are penalty free. You will still have to pay income taxes on the funds taken from a traditional IRA account. The Internal Revenue Service taxes earnings from a Roth IRA in this case, but not the original contributions. If the amount spent for education expenses is equal to or less than the contributions, you can withdraw the money from a Roth IRA without paying taxes. The child's IRA or the parent's IRA account, or both, may finance the child's education.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts, or ESAs were originally Education IRAs. The name changed because ESAs are really college savings accounts. You can only use an ESA to pay for qualified education expenses. The parents own the ESA, not the child, thus they have little in common with IRAs. Since Coverdell ESAs have complex rules, check them out thoroughly along with other college savings accounts like 403B and 529 plans. If your primary motivation in starting an IRA for your child is to pay for college, it is good to know that your child can contribute to an IRA and you can contribute to a college savings plan for him.

Use your own Roth IRA for your child's inheritance and retirement

Use your Roth IRA for your child's benefit.

The Roth IRA is an excellent estate-planning tool. Traditional IRAs require the owner to take mandatory distributions every year starting at age 70½. But, Roth IRAs do not require any withdrawals during the owner's lifetime. When the owner dies and has a spouse, the spouse beneficiary can re-title the IRA as her own. Then she can avoid taking any withdrawals as the Roth continues to build tax-free earnings. When the child finally inherits, he must start withdrawals within five years, but he will reap the benefits of a long earnings period. Using a Roth IRA as a tax-advantaged inheritance for your children is one way to provide for their future retirement. Changes in the estate tax law could make this strategy more or less desirable depending on new legislation and your personal net worth.

References

• E Trade: IRA for Minors
• IRS: Coverdell Education Savings Accounts
• et Ready for College: Withdrawls from Traditional or Roth IRAs
• Fairmark: Taxable Distributions for Roth IRAs

Resources

• Kiplinger: Can Your Child Open a Roth IRA?
• Fairmark: Roth IRAs for Minors