Setting Up a Retirement Account for Your Child

By Rebecca Lake · March 15, 2023 · 8 minute read

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Setting Up a Retirement Account for Your Child

Opening a tax-advantaged individual retirement account (IRA) for minors becomes possible once they start earning income. Even babysitting or lawn-mowing money counts.

A custodial IRA offers certain advantages: It can jump start a child’s interest in investing, and possibly help build their future nest egg. But there are annual contribution limits and other potential drawbacks to consider, such as the child’s eligibility for college financial aid.

How to Open a Retirement Account for Your Child

Opening a retirement fund for a child means opening a custodial IRA. Generally speaking, a custodial account is one that’s owned by an adult — a parent, grandparent, or legal guardian — on behalf of a minor.

The adult does the investment planning for their child, and manages the money in the account until the child reaches the age of majority (it varies by state). At that point, all the money in the account belongs to the child.

Steps to Opening a Retirement Account for a Child

Here’s how opening a retirement account for minors typically works.

Step 1: Choose a Brokerage

Custodial IRAs are offered by many brokerages, so you’ll need to choose where to open yours. This could be the brokerage where you currently have your investment accounts or a different one.

When deciding on a custodial IRA, consider the range of investments offered, the fees you’re likely to pay, and how easy it is overall to open and manage new accounts. For example, some brokerages let you set up an IRA for a child online, while others require you to fill out and mail in the necessary paperwork.

Step 2: Complete the Application

On the application for a custodial IRA, the brokerage will typically ask for specific information, including:

•   Contact information (e.g., your phone number, email address, and mailing address)

•   Personal information about yourself, including your name, date of birth, and Social Security number

•   Personal information about your minor child, including their name, date of birth, and Social Security number

•   Employment information, if applicable

You’ll also need to share routing information and the account number for the bank account you plan to use to make contributions. If you’re moving money from another brokerage firm, you’ll be asked to provide the account number and type.

Step 3: Choose an IRA Type

Should you choose a traditional or a Roth IRA for your child? Both offer tax benefits and both have the same annual contribution limits for kids. For minors, a Roth IRA typically works better. One reason is that the child’s tax rate is typically quite low, and likely much lower than their tax rate will be upon retirement.

Step 4: Fund the Account and Choose Investments

Once you’ve opened a retirement account for a child, you can fund the account using your linked bank account and then make your investment selections. As the custodian, you choose how the money in the IRA is invested, though you might want to talk to your kids first to get their feedback. Generally, custodial IRAs can offer the same investment selections as IRAs for adults, which can mean stocks, mutual funds, exchange-traded funds (ETFs), bonds and other securities.

Recommended: How Much Should I Have in My 401(k) By Age 30?

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Different Types of IRAs for Children

As mentioned earlier, there are two main types of IRAs you can open for a minor child: traditional and Roth. The main difference lies in their tax treatment. The IRS regulates contributions to and withdrawals from each type of IRA.

Traditional IRA

A traditional IRA is funded with pre-tax dollars. The IRS allows eligible taxpayers to claim a deduction for contributions. When you take money out in retirement, you pay taxes on the earnings.

Traditional IRAs can make sense for people who can benefit from tax-deductible contributions. That might be less valuable to your child than the tax benefits that a Roth IRA could yield.

Roth IRA

You start a Roth IRA using after-tax dollars, so you get no tax deductions on your contributions. But they can offer something else: tax-free qualified distributions. This means no matter what tax bracket your child is in when they retire, they can withdraw their money from a Roth IRA tax-free.

Roth IRA withdrawal rules also allow contributions to be withdrawn at any time, tax- and penalty-free.

Funding a Child’s Retirement Account

Both traditional and Roth IRAs have annual contribution limits, and you have to contribute earned income. For 2023, the IRA contribution limit is $6,500. If you’re 50 or older, you can add another $1,000 to help you catch up for retirement.

The same rules apply to custodial IRAs. In 2023, kids can contribute an amount equal to their earnings for the year or the $6,500 limit, whichever is lower. So if your child makes $5,000 by babysitting and mowing lawns, the most they’d be able to add to their IRA is $5,000.

Again, it’s important to remember that kids need to have income (specifically, taxable compensation) to open and contribute to a traditional or Roth IRA. According to the IRS, that includes:

•   Wages

•   Salaries

•   Commissions

•   Tips

•   Bonuses

•   Net income from self-employment

Investment income, including interest and dividend income, doesn’t count as income that can be contributed to the child’s IRA, under IRS guidelines.

Can a Parent Contribute to a Child’s IRA?

A parent can contribute to a child’s IRA only if that child has earned income of their own for the year.

Again, contributions to a child’s IRA must not exceed their allowed limit for the year. Going back to the previous example, in which your child earned $5,000, they could technically put all of that money into their IRA. Or you could offer to split the difference and let them put in $2,500 while contributing the remaining $2,500 yourself.

Keeping careful records of your child’s earnings for the year can help you avoid contributing too much to their IRA. Also, offering to put in an equivalent amount (without breaching the limit) can be a good motivator for kids to invest in their IRA.

Recommended: IRA vs. 401(k): What’s the Difference?

Benefits of a Child Opening a Retirement Account

Opening up a Roth IRA for a child can benefit them in several ways.

•   Kids can get an early taste of what it means to invest money rather than saving it. The IRA can be a teaching tool to help a child learn how the market works and the importance of setting long-term financial goals.

•   Kids who start saving for retirement at an early age have the ability to take full advantage of the power of compounding interest. A child who contributes $5,000 each year starting at age 14 and earns a 7% annual return, for example, could have $2.3 million saved for retirement by age 65. Running the numbers using a Roth IRA calculator can give you an idea of how much of a head start on growing wealth you might be able to give your child by opening a minor IRA.

•   The money in a Roth IRA for a child is tax-free when they take qualified distributions. This can result in substantial tax savings if they’re in a higher tax bracket when they retire.

Cons of a Child Opening a Retirement Account

Before you open a traditional or Roth IRA for a child, there are some drawbacks to consider.

•   While contributing to a Roth IRA may offer some long-term benefits, there are no guarantees, and the money is then locked up until your child turns 59 ½ (although early withdrawals are possible, and might incur a penalty).

•   A Roth IRA might affect your college-bound child’s financial aid eligibility. Just having money in a Roth IRA won’t cause any snags if your child is applying for federal student aid. But if they withdraw contributions from their Roth IRA for any reason — including paying for college expenses — that money is counted as income, which may affect eligibility for need-based aid.

•   Investments within a custodial IRA entail some level of risk, as with all investments.

Pros

Cons

An IRA can be a good way to teach kids about investing and the stock market. Funds in an IRA are typically restricted (although Roth contributions can be withdrawn at any time, penalty-free).
Starting an IRA for a child at a young age means they have more time to benefit from compounding interest. Withdrawal of contributions from a Roth IRA could affect a child’s financial aid eligibility.
Qualified distributions are tax-free in retirement. Investments within a custodial IRA entail some level of risk.

Open a Retirement Account Today With SoFi

IRAs can be a valuable addition to a retirement savings strategy if you’re interested in investment planning for children or for yourself. If you haven’t started saving for the future yet or your child is starting to earn income of their own, there’s no time like the present to consider opening an IRA.

When investing for retirement with SoFi, you can set up a traditional IRA, Roth IRA, or SEP IRA. The SEP IRA is designed for people who are self-employed. All three can offer tax benefits while helping you get closer to your retirement goals.

Easily manage your retirement savings with a SoFi IRA.

FAQ

How do I set up a retirement account for a minor?

To get started, find out which brokerages allow you to open custodial IRAs for minor children. Then you need to choose a brokerage and IRA type, fill out the appropriate paperwork, and make a deposit or transfer to fund the IRA.

How do I give my kids an IRA?

You can open an IRA for your child once they have earned income of their own. This would be a custodial account: You own it until the child reaches adulthood, at which point it belongs to them. The other way to give an IRA to your kids is to name them as your IRA beneficiary when you pass away. If the child is a minor when they inherit the IRA, they would need a custodian to manage it for them.

When can I start a 401(k) for my child?

You can’t start a 401(k) for a child, unless you run a business that offers a 401(k) to its employees and your child works for you. You can, however, open an IRA for a minor child who has earned income, and make contributions to it on their behalf, as long as the total contributions don’t surpass the amount earned by the child that year.


Photo credit: iStock/VioletaStoimenova

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