Penny jars and coin sorters are all well and good, but if you really want to jump-start your child’s savings habit, you may want to think bigger. Think Roth IRA, in fact.
A child who has a job and earns income is just as eligible as an adult for a Roth IRA, which allows users to contribute after-tax money and receive tax-free growth and distributions.
Both adult and child Roth IRA accounts have to follow the same rules about annual contribution amounts and the like. (The maximum for those under age 50 is the lesser of $5,500 or your annual income.) And for minors, an adult has to open a custodial Roth account, with the adult as custodian and the child as owner, until the child reaches legal adulthood.
Parents who set up an account within those limitations can start a child on the road to financial security without adding any worries about the tax man. They can also create the account as a gift for the child by depositing their own money instead of the child’s earnings, provided they do not exceed the amounts the rules allow.
“This is a wonderful learning opportunity for the child to learn about saving for the long term,” said Keith Bernhardt, vice president of retirement and college for Fidelity Investments. “The two biggest things for hitting a savings goal are, starting to save early and saving consistently.”
Fidelity earlier this month launched a Roth IRA for kids, though other firms offer these accounts as well.
It may be hard for kids to grasp the appeal of long-term savings, since retirement is at best an abstract concept for most of them. In addition, kids are bombarded with advertisements urging them to spend now: One study estimated that children age 2 to 11 saw roughly 25,600 television ads per year.
Then there is the matter of today’s extremely low interest rates, which make it hard for parents to illustrate how savings grow over time. But Bernhardt said kids’ time before retirement is so long that the effect is still clear.
Bernhardt said that after his son earned some money shoveling snow, he opened an account for him. The amount was well below the $2,000 or $2,500 minimum required to invest in many mutual funds, so they invested “on the ETF [exchange-traded fund] side,” Bernhardt said.
To illustrate how the savings could grow, Bernhardt demonstrated to his son what would happen with a 5 percent return in the short run, then over a 50-year time horizon.
“His eyes lit up, and he said, ‘Wow,'” Bernhardt recalled. Then his son began asking what would happen if he added to the account the following year.
“Once people see it, it really resonates,” Bernhardt said.
Most minors have little in the way of earned income, which puts them in the lowest tax bracket. That makes Roth accounts even more useful for young savers, since their after-tax income — the amount they can deposit in a Roth — is typically so close to their gross income.
When kids earn income that is reported to the IRS on a W-2 form, it is easy for parents to know how much can go into a Roth IRA. But the many kids who earn money from babysitting, snow shoveling and the like can also open accounts, according to Ted Sarenski, a practicing CPA and a member of AICPA’s Personal Financial Planning Executive Committee.
Those earners need to file a Schedule C tax form for self employed workers, he said, and it is best to keep real records of the earned income, like bank deposit slips or a log of when babysitting or snow shoveling took place, and for whom. Minors do not have to pay income or Social Security tax on earnings below $400, he said, but they need to have that Schedule C on file to demonstrate their eligibility for a Roth IRA.
Filing with the IRS is work, Sarenski said, but it can be worthwhile.
“I find it to be a good teaching experience,” he said. “If they go to college, they are going to have to learn how to budget. It’s a teaching opportunity.”
Although Roth IRAs are intended to provide savings for retirement, it is possible for a minor to withdraw Roth IRA money without a penalty to help pay for college, provided it has been in the account for five years, Berhnardt said. But he cautioned that doing so can mess with financial aid.
When minors reach adulthood, they can also withdraw contributions to a Roth IRA that they have had for more than five years without penalty, Sarenski said. But he said that ability creates another teaching moment for parents to explain the importance of keeping savings intact.
Even with that potential downside, Sarenski views Roth IRAs for minors as a good idea, regardless of the paperwork and recordkeeping.
“It’s a great time to get them started thinking about saving for retirement,” he said. “A long time ago, there weren’t ATMs. You saw your parents paying bills with cash or they wrote checks. In this electronic age, I think it’s more important to teach these things, because they don’t see them going on.”
— By Kelley Holland, special to CNBC