Does Your Kid Need an IRA?

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It's a big day when you open a savings account for your child, but opening an investment account on their behalf takes the financial conversation to a whole new level — especially when you invest through a Roth IRA. Here are a few reasons why your kid needs one.

1. They'll Learn About Investing — And More

Investing is arguably the most complicated and intimidating aspect of money management, so the earlier you get your kids acclimated to the process, the better.

You could open a plain old investment account for them, but investing through a Roth IRA provides powerful additional benefits by teaching them about (and saving them) taxes.

2. They Start Saving for Big Purchases — Like College or a House

A Roth IRA is a flexible, tax-efficient way to invest. Contributions can be withdrawn at any time without taxes or penalties. Earnings can be withdrawn on the same basis as well if the account has been open for at least five years and the money is used for qualified college expenses or a first-time home purchase (up to $10,000).

Of course, the Roth really shines as a retirement savings vehicle. All of the money — contributions and earnings — can be withdrawn tax- and penalty-free after age 59½, and the benefit of those tax-free earnings really adds up over time. So, if your child has another way to pay for college and a house, all the better to keep adding to the account and let it build for later life. But it's nice to have the flexibility to pull money out earlier if needed for college or a house.

3. They'll Still Be Eligible for Financial Aid

Money held in an IRA, whether owned by a parent or a child, does not impact the financial aid calculation, at least not initially. By contrast, 20% of the money a student holds in a taxable investment account will reduce the financial aid they're eligible for.

However, if money is withdrawn from an IRA to pay for college, that money will reduce financial aid. It's treated as income, 50% of which is considered to be available to pay for school. One workaround is to use such money only to pay for the last year of school since no aid will be required the following year.

How to Set Up an IRA for a Minor

Setting up a Roth for a kid is as straightforward as setting one up for yourself, but there are a couple of wrinkles to be aware of.

Qualifying for an Account

A child has to have earned income in order to qualify for an IRA, which can come from a job or their own self-employment efforts, such as babysitting, mowing lawns, shoveling snow, pet walking, and more.

As long as the child meets the income qualification, they don't have to contribute their own money; parents or others could make IRA contributions on their behalf. Either way, annual deposits to the account cannot exceed the amount of income earned by the child, and is currently capped at $5,500 per year.

Opening an Account

The account must be set up as a custodial account since you need to be the "age of majority" (18–21, depending on your state) to have such an account in your own name. Any adult can open a custodial account on behalf of a minor — a parent, grandparent, other relative, or just a friend of the child. The assets transfer to the young person when he or she reaches the age of majority.

Many brokers, including Fidelity, TD Ameritrade, and Schwab, offer custodial IRA accounts with no or very low minimum opening balance requirements.

Funding an Account

As for specific investments to consider after opening an account, mutual funds may not be the best choice since they often require $1,000 or higher minimum investment amounts. You might consider exchange-traded funds (ETFs) instead. They can be purchased one share at a time, offer great diversification, and many brokers, including the ones mentioned above, offer plenty of commission-free ETFs.

Opening a Roth IRA for your child is one of the best financial moves you could make. Just be sure to involve them in the process of choosing investments and understanding the tax benefits. That combination of education and hands-on experience will set them on a path toward becoming a knowledgeable, confident, successful investor.

Have you opened an IRA for a child?