Yes, you can— and it’s a great idea if your child (or grandchild) is eligible! Opening an IRA for a child allows them to take full advantage of the power of compounding over time — that investment can provide a fantastic start to their retirement account. Additionally, involving them in conversations about the account teaches them financial literacy, the importance of saving for retirement and introduces them to financial vehicles and investing principles.
The minimum age to open an IRA means that children under 18 (19 or 21 in some states) cannot open an account on their own, so an adult can open a custodial account on their behalf.
What is Eligible Income?
There is no age requirement for a custodial account, but there is an income requirement. The child needs to have earned income from some source to open the account. This source could be a job with an employer, such as delivering papers, serving as a lifeguard or working at the local fast food restaurant.
Children are also eligible for a custodial IRA account if they are entrepreneurial and earn money through efforts like mowing, babysitting or walking dogs. They should report their earnings as self-employment income on taxes and keep records that include type and location of work, for whom it was done and payment amount.
Money from an allowance or a cash gift does not count as income. However, you may be able to pay your child for work done around the house if it is an appropriate payment amount for legitimate work. For example, you can pay them for caring for their younger siblings or performing farm work. It helps prove that this is payment (and not allowance) if the child does similar work for people outside of the family.
If you have business owners in the family, children can be paid for age-appropriate work done in support of that business, such as if a child acts as a model to sell clothing made by a family member, helps file paperwork in the office or assists in raising livestock. Be sure to keep clear documentation of the work, including when and where the work was performed and how much they were paid for it.
Who Can Contribute to a Custodial IRA?
The account belongs to the child, but anyone can contribute to the IRA for the child as long as they don’t exceed the amount of the child’s earned income. Where the money comes from doesn’t make a difference. For example, if the child earns $2,000 for their work over the summer, the parent can allow the child to keep that as pocket money and contribute up to $2,000 themselves to the account.
However, when others are contributing to the IRA they should keep gift tax rules in mind, as the contributions will go against the limit on tax-free gifts you can make to one person each year. It’s also important to note that the IRA is in the child’s name, so the child — not the contributor — will receive any tax benefits from it.
The yearly contribution limit is either the federally-set IRA limit ($6,000 in 2021) or however much the child earned that year. No matter the source of the income, it’s important to ensure appropriate actions are being taken in relation to the child’s tax liability.
Why is a Custodial Roth IRA Better for Children?
Roth IRAs favor those who’ll be in a higher tax bracket later in life, so they are a good choice for children. Currently, there are also no required minimum distributions (RMDs) on Roth IRA accounts, so that money is free from restrictions.
Roth IRAs also have looser guidelines that offer greater flexibility. For example, contributions can be withdrawn at any time without penalty; penalties don’t kick in until investment earnings are withdrawn. Roth IRA accounts can also be used to help pay for qualified education expenses. Your child would have to pay taxes on earnings but can withdraw the money penalty-free. Finally, up to $10,000 in investment earnings can be withdrawn penalty- and tax-free for a first-time home purchase. These guidelines provide an array of opportunities for your child or grandchild.
How Do I Open a Custodial IRA Account?
Not all financial services providers offer custodial IRA accounts, so the first step is to find a firm that offers custodial IRAs. Be prepared to provide standard information on your child and yourself, such as social security numbers, to open the account.
There is no real difference in a custodial account versus a standard Roth IRA account, other than perhaps a lower minimum. The adult makes the decisions about investments and assets until the child reaches the age in which it can be turned over to them. The account then turns over and becomes the adult child’s asset, providing a strong financial foundation.
Talk with a Farm Bureau financial advisor today about helping the next generation get a strong start.