Congratulations! Your child has a job!
Now what?
How about a Child IRA? Your child won’t be thinking of this, but you should. It doesn’t matter if the work is a full-fledged 1099-producing summer job or just a little gig helping out with the neighbor’s chores.
You might not think this is a top priority, but according to experienced financial professionals, it should be.
“At many of our workshops, presentations and seminars, we question the audience and ask them if they learned to save at a young age and get a few responses,” says Jill Gleba, Founder & President at Gleba & Associates in Troy, Michigan. “When we ask if they learned how to invest, we are lucky to get one person to respond with a yes. It’s sad.”
Why might this be the case? For one thing, kids can’t set up a Child IRA for themselves. They aren’t allowed to enter into the agreements necessary to establish one. Usually, a parent (or a grandparent) must take the lead.
“An adult, which is defined as someone over the age of 18 in most states for this purpose, must be the one to open the ‘custodial IRA’ account,” says Jason Dall’Acqua, President at Crest Wealth Advisors in Annapolis, Maryland. “This person is typically the child’s parent and is referred to as the account custodian. All of the money in the account belongs to the child, but the assets are managed by the custodian until the child reaches the age of majority, which is either 18 or 21 depending on the state.”
The first step, then, to helping your child fund a Child IRA is to set one up. This vehicle, essentially the same as an IRA but with a twist, isn’t always on the menu, so you’ll need to ask your provider if it has a Child IRA (which they may call a “Minor IRA” or “Custodial IRA”).
“Since not every brokerage firm or bank will offer custodial IRA accounts, you may need to check around to various providers to find one that does,” says Tiffany Lam-Balfour, Investing and Retirement Specialist at NerdWallet in San Francisco. “For example, Fidelity and Charles Schwab both offer custodial IRAs.”
Once you establish the Child IRA, someone needs to fund it.
Notice the word “someone.” The money doesn’t need to come from the child.
“Parents and grandparents can fund the IRA on behalf of the child, as long as the amount is not greater than the child’s earned income for that year,” says Dominic Trupiano, VP of Sales & Marketing at Artesys (R.T. Jones Capital Equities Mgmt, Inc.), located in St. Louis. “Keep in mind, normal gift tax rules apply.”
There are two key points here. First, no matter who makes the contribution, you can’t contribute more than what the child earned. Second, there may be other tax implications for the person making the contribution, but nothing that should worry you.
“Anyone can contribute to a child IRA as long as it does not exceed the child’s earned income for the year in which the contribution is being made,” says Jazmin Gabriela Carpenter, VP, Investments at Wedbush Securities in Los Angeles. “For example, Ella made $2,500.00 from dog sitting/walking during the summer. I can choose to let Ella spend her $2,500.00 however she chooses and I can contribute $2,500.00 to her child IRA out of my own money. Important note: I would not receive the tax deduction since the contribution was made to Ella’s IRA. Ella would receive the tax benefit.”
If multiple family members want to chip in, it’s best if this is coordinated through the primary adult (i.e., the one who initially set up the Child IRA).
“The account custodian, typically the parent, should make contributions into the account on behalf of the child,” says Dall’Acqua. “It is important to understand that the child must have earned income in order to receive contributions into the account. The contributions cannot exceed the lesser of the child’s earned income or the maximum allowable IRA contribution for that year. A grandparent is allowed to make a deposit into the account. However, due to the contribution limitations it is best to have the custodian make contributions so that one person is tracking total contributions. In that case, the grandparent can make a gift to the child and the custodian (presumably the parent) can make the contribution on behalf of the child.”
In fact, you can use this giving as a way to encourage your child to get a job. Think of it being similar to a 401k company match with you playing the part of the company.
“A parent or grandparent can choose to incentivize a young saver like an employer might,” says Christie Whitney, VP of Investment Advice and Director of Planning Rebalance in Palo Alto, California. “Say you choose to match each dollar your child saves or something more generous. It’s not important where the contributions come from. What matters is that the young earner did in fact earn the amount that ends up in their account.”
But wait! There’s more!
Here’s something you’ll need to talk to your accountant about, but if you own a small business (whether full time or a side gig) that is organized in a certain way, you can help create a 100% tax free retirement savings fund for your child.
“Parents who own a business (sole proprietorship or partnership in which each partner is a parent of the child) can also hire their minor children as employees without paying for Medicare, Social Security and Federal Unemployment tax,” says Lam-Balfour. “By doing so, your child can contribute to a Roth IRA and the parents’ business gains a business tax deduction. You’ll have to issue a W-2 to your child and wages paid must be justifiable, but it may be a worthwhile endeavor depending upon your circumstances.”
Getting a child started to save for retirement early through a Child IRA yields dividends far beyond the dollars accumulated. It shows the child the reward of compound growth and the importance of steady financial discipline. And for some parents who own their own business, it can be a way to transfer wealth to the next generation tax-free.