Once your child begins working and earning income, setting up a Roth IRA can be both an excellent way to teach your child about money management and a tax-effective means of growing a fund for the child’s future needs.
Why a Roth?
Parents can choose to set up either a traditional or a Roth IRA for their minor children who earn income, but because children rarely earn enough to be subject to tax, a Roth is almost always the preferable choice. A traditional IRA allows the account holder to deposit pre-tax dollars with distributions taxable upon withdrawal. While this is an attractive option for those subject to a higher tax rate than they expect to pay in retirement, it offers no tax benefit to anyone who is not obligated to pay income tax. If your child earns less than the standard deduction ($6,200 for 2014), then his or her tax obligation will be zero. Even earnings up to $15,275 are taxed at a rate of only 10%. Given the very low or nonexistent tax obligation of the vast majority of children, a Roth IRA, which is funded with post-tax dollars and allows tax-free distributions, is usually a far more beneficial choice.
You can withdraw contributions to a Roth IRA at any time without penalty, although restrictions apply to distributions of earnings on the account. This flexibility is another reason that the Roth is a great option for kids. If necessary, your child will be able to tap into what has been saved for future expenses prior to retirement, such as higher education, a home purchase, or emergency needs. Of course, withdrawing money prior to retirement undercuts the fund’s earning capacity, so the choice to take distributions should be made judiciously.
What are the rules?
Parents can set up a Roth for a child of any age who has earned income from a job, assuming the child’s job brings in less than $129,000 in 2014. You can not contribute more than the child actually earned from work, but the money does not have to come directly from the child. If you wish to match the child’s earnings dollar for dollar, for example, your child would be able to keep his or her earnings while you fund the IRA. Another possibility is to ask your child to contribute a percentage of earnings to the account while you make up the difference. This strategy can help to teach your child financial discipline and see the reward that it brings down the road.
In 2014, the maximum contribution to a Roth IRA is $5,500. You can continue to make contributions to a Roth through the tax deadline for the year. For example, if you child has not reached the $5,500 limit by the end of 2014, you can make additional deposits until April 15, 2015 for the 2014 tax year.
For a minor child, a custodial Roth IRA is used. Not every financial institution offers a custodial Roth, but many do. The custodian (usually a parent) makes all decisions about investments and withdrawals until the child reaches adulthood. Some institutions allow for automatic monthly transfers to the IRA from a checking or savings account. This is also a fine choice for helping your child develop financial discipline; learning to budget for savings is a foundational skill for lifelong financial planning success.
Where can I open a Roth IRA?
Many different types of Roth IRAs are available from a range of financial institutions, including banks, mutual fund companies, brokerage firms, and insurance companies. For more information about the differences among these offerings, read our blog post, “How to Shop for Your IRA.” The best way to develop your family financial planning strategy is in consultation with a qualified financial advisor. A professional financial and tax advisor can help you to make the most of your and your family’s earnings by applying extensive knowledge of available investments and tax benefits. Contact us for a free consultation at our office in West Des Moines.
Material discussed herein is meant for general illustration and/or informational purposes only. Because individual situations will vary, the information shared here should be used in conjunction with individual professional advice.