By Christopher Carosa
Here’s the deal. For all the talk of fancy and complicated ways to help your child save, there’s one simple vehicle that everyone seems to ignore. That’s too bad because by exercising a conscious discipline for only a few short years, your teenager can retire with a $2.5 million head start.
In fact, it’s so easy, a child can do it. Literally.
Yet for something so easy, it’s all but shunned as a planning vehicle. Why aren’t more people using it?
Well, the quick answer is because it’s not even on their radar. In fact, once they find out about it, once they hear a few real-life examples, parents kick themselves for not thinking of this obvious golden opportunity when their children were younger.
What is a Child IRA?
Essentially, it’s just like the IRA you can get for yourself, only it’s for a minor child.
An IRA is a contract between you and the hosting financial institution. For example, this hosting institution could be a bank, a broker, or a mutual fund. It’s a personal account, sometimes a formal trust account, and sometimes a standard custodial account.
In either case, like any other investment account, you can trade securities in it (including stocks, bonds, and mutual funds). There may be some limitations on the kinds of assets you can place in the IRA. That’s generally determined by the hosting institution.
You also get to decide if you want to set up a traditional IRA – one where your contributions are tax-deductible in the current year but taxed when withdrawn from the IRA. Or a Roth IRA – where your contributions are after-tax but you can withdraw from, when eligible, without paying any taxes.
All this applies to both an adult IRA and a Child IRA.
So, what’s the difference?
How Can You Set Up a Child IRA?
Minor children are not allowed to enter into contracts until they reach a certain age as determined by the state they reside in (usually 18 years, but older in a few other states). As a result, a parent or guardian must establish the Child IRA on behalf of the child. (Note: Some institutions will call Child IRAs Minor IRAs, Minor Child IRAs, or Custodian IRAs. They all mean the same thing.)
The only difference, then, between an adult IRA and a Child IRA is that the parent or guardian must also sign the Child IRA. After that, everything else is the same.
It’s important you make the right decision regarding what type of Child IRA you’ll be setting up. Because children tend to pay little or no taxes (because they earn so little), most financial professionals recommend selecting the Roth version of a Child IRA.
Just like setting up your own IRA, you won’t necessarily need to talk to a financial professional unless you feel getting expert advice will provide you a shortcut that allows you to get it right the first time.
Yes, a Child IRA is Really this Easy
You’re familiar with the old adage “It’s so easy a child could do it.” Well, it certainly applies here.
Once you’ve set up a Child IRA, your child (or you) can start contributing to it. Just like any other IRA, contributions are limited to actual dollars earned or $6,000 (in 2021), whichever is smaller.
The limiting factoring is the income your child earns in the tax year. This is something only your child could do. You can’t do it for your child.
Once that income is earned, however, the source of the dollars used for the Child IRA contribution can come from anywhere. This is why so many parents set up Child IRAs without much input from the child. They can simply make the contributions themselves by matching the child’s earned income, at least until the child is mature enough to see what’s going on. (Spoiler alert: Once that Child IRA starts getting well into five digits, it’s amazing how fast those kids mature!)
Now comes the best news of all. Imagine your child investing the money in the Child IRA. They’d probably invest poorly, at least in the beginning. They probably won’t even get close to matching the historic average annual return of stocks (11%).
OK, so they’re bad investors. Maybe they’re so bad (in the beginning) that they earn 3% below the historic average annual return, i.e., 8%. Given this sour news, do you know how much money your child’s Child IRA would grow to if your child started contributing the maximum amount ($6,000) as a teenager (age thirteen) and continued doing so every year until they graduated from high school (age eighteen)?
When your child retires at age 70 (because that will probably be the retirement age by then), that Child IRA will have grown to more than two-and-a-half million dollars!
But a Child IRA Could Be Easier
The pathway to a multi-million-dollar retirement is easy, but there are rules to this road that limits the number of people who can travel it. Not every teenager can earn $6,000. Not every parent has the disposable income to match those earning and contribute to a Child IRA
Face it, for many people, it’s hard to capture the power of and live the serenity from the Child IRA.
But it could be made easier.
Congress has within its power to change things without any out-of-pocket costs. It could allow contributions to Child IRAs the same way it allows contributions to 529 plans. These would be after-tax contributions (so these Child IRAs would have to be Roths) that would have no earned income requirement. This would make all children eligible.
Furthermore, like 529 plans, anyone – family, friend, or even Warren Buffett – could contribute to any child’s Child IRA!
Imagine Oprah Winfrey handing out Child IRAs to an entire studio audience (“You get a Child IRA! You get a Child IRA! You get a Child IRA!...”). That’s how easy it could be.
To Learn More…
Talk to your financial, investment, or tax professional. These folks will tell you how your child can start a Child IRA. Alternatively, parents with teenagers can pick up the new book The Parent’s Guide to Turning Your Teen Into a Millionaire: And How To Do It Before High School Graduation! (available in paperback and ebook). Parents with younger children might want to try From Cradle to Retirement: The Child IRA: How to start a newborn on the road to comfortable retirement while still in a cozy cradle (in paperback only).
About the author: Christopher Carosa
Christopher Carosa is an award-winning researcher, journalist, and on-line news producer. He's the author of several books including two on the Child IRA. His latest release, "Hamburger Dreams" was recently ranked #1 on Amazon's New Releases in the Historical Essay category.
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