Q & A: IRAs for your Children
Q & A: IRAs for your Children
Establishing a retirement plan for a child might, initially, sound a bit strange—or at least premature. Truly, it is not. Establishing an IRA for your children or grandchildren can help them achieve financial independence in retirement and, possibly, for the rest of their lives. That claim may raise some questions in your mind. How is it possible? Simply stated, given enough years of tax-deferred compounding of investment earnings, an IRA can yield some amazing numbers. (See the examples below.)
How can my child set up an IRA?
Actually, although the IRA will be your child’s, you set it up and serve as custodian until the child reaches majority. But your child rather than you is the “owner” of the IRA and is subject to all the income requirements and rules.
How much can my child contribute?
The contribution rule is the same for your child as it is for you. For 2006 the maximum allowable contribution to a traditional IRA or Roth IRA is $4,000. (If you are age 50 or older, you can contribute up to $1,000 more.) But there is a catch, one that is especially relevant when we’re talking about children. If the IRA owner’s earned income (income from wages, not from investments) is less than the maximum contribution amount, the contribution is limited to the income that he or she earns.
How can I convince my child to give up his or her earnings and put them in an IRA?
You don’t have to. You can make the contribution, by making a gift to your child of the contribution amount (up to his or her earned income). The annual gift tax exclusion ($11,000 in 2005 and $12,000 in 2006) shelters your gift from tax.
Which is better, a traditional or a Roth IRA?
A Roth IRA generally is considered to work best for children. First, withdrawals from a Roth IRA are tax free, provided that all the conditions are met. And there are no required distributions when the owner reaches age 70 1/2. But though contributions can be withdrawn tax free at any time, for the earnings to get the preferential treatment, a Roth IRA must be owned for at least five years and the owner be at least age 59 1/2. A traditional IRA allows pretax contributions, but tax is owed on withdrawals. That may not be a big benefit when your child is relatively young and owes little or no tax on that income. Both IRAs permit penalty-free withdrawals for education expenses and $10,000 in home-buying expenses for the first residence purchased.
What kind of wage income are we talking about?
Paying your child an allowance for helping out at home isn’t likely to be “earned income” and survive IRS scrutiny. On the other end of the spectrum, a regular paycheck from a business or the like clearly qualifies. Whether money from in-between situations—baby-sitting, lawn mowing, snow shoveling—is earned income is less certain. The best approach is for your child to keep accurate and detailed records (dates, names of employers, amounts paid for each job) of his or her earnings. If you are employing your child at your business, be sure to treat him or her as you would any other employee.
Is there a downside to setting up an IRA for my child?
Potentially, there’s a major one: Once your child reaches majority, he or she is free to take funds from the IRA as he or she pleases, even close it out. If all the Roth IRA conditions aren’t met, in addition to tax on the investment earnings, penalties could apply as well. And who knows how the money will be spent?
Examples: Big things can happen to small contributions
Just how big can a Roth IRA grow? Here are two examples (all names and circumstances fictitious):
• The Smiths set up a Roth IRA for their 16-year-old daughter, Sarah, who works after high school and during summers and also will work throughout college, earning at least $3,000 a year. Each year, for six years, the Smiths contribute $3,000 a year to the IRA for Sarah. There are no subsequent contributions. Assuming an investment rate of return of 6% a year, here’s what will accumulate in Sarah’s IRA:*
After the six years of contributions end (at age 22): $20,926
After ten more years: $36,526
When Sarah reaches age 65: $249,860
• The Petersons set up a Roth IRA for their 16-year-old son Al, who also works after high school, during summers and throughout college, earning enough to allow the Petersons to make $3,000 a year in contributions for him. At age 22 Al takes on the responsibility for making contributions from then on, putting $5,000 a year into his IRA.** Assuming retirement at age 65 and an investment return of 6% a year, here’s what will accumulate in Al’s IRA:*
After six years of $3,000 contributions: $20,926
After ten additional years of $5,000 contributions: $102,430
When Al reaches age 65: $1,187,398
*This rate is hypothetical, chosen for illustrative purposes only. It does not represent the past or future performance of any specific investment or mutual fund.
**$5,000 per year is the maximum allowable contribution for 2008 and after, assuming that the increases that became law in 2001 become permanent instead of expiring after 2010. Contributions to a Roth IRA may be limited or unavailable above certain adjusted gross income limits.
We hope you found this article about “Q & A: IRAs for your Children” helpful. If you have questions or need expert tax or family office advice that’s refreshingly objective (we never sell investments), please contact us or visit our Family office page or our website at www.GROCO.com. Unfortunately, we no longer give advice to other tax professionals gratis.
To receive our free newsletter, contact us here.
Subscribe our YouTube Channel for more updates.
Alan Olsen, is the Host of the American Dreams Show and the Managing Partner of GROCO.com. GROCO is a premier family office and tax advisory firm located in the San Francisco Bay area serving clients all over the world.
Alan L. Olsen, CPA, Wikipedia Bio
GROCO.com is a proud sponsor of The American Dreams Show.
The American Dreams show was the brainchild of Alan Olsen, CPA, MBA. It was originally created to fill a specific need; often inexperienced entrepreneurs lacked basic information about raising capital and how to successfully start a business.
Alan sincerely wanted to respond to the many requests from aspiring entrepreneurs asking for the information and introductions they needed. But he had to find a way to help in which his venture capital clients and friends would not mind.
The American Dreams show became the solution, first as a radio show and now with YouTube videos as well. Always respectful of interview guest’s time, he’s able to give access to individuals information and inspiration previously inaccessible to the first-time entrepreneurs who need it most.
They can listen to venture capitalists and successful business people explain first-hand, how they got to where they are, how to start a company, how to overcome challenges, how they see the future evolving, opportunities, work-life balance and so much more..
American Dreams discusses many topics from some of the world’s most successful individuals about their secrets to life’s success. Topics from guest have included:
Creating purpose in life / Building a foundation for their life / Solving problems / Finding fulfillment through philanthropy and service / Becoming self-reliant / Enhancing effective leadership / Balancing family and work…
MyPaths.com (Also sponsored by GROCO) provides free access to content and world-class entrepreneurs, influencers and thought leaders’ personal success stories. To help you find your path in life to true, sustainable success & happiness. It’s mission statement:
In an increasingly complex and difficult world, we hope to help you find your personal path in life and build a strong foundation by learning how others found success and happiness. True and sustainable success and happiness are different for each one of us but possible, often despite significant challenges.
Our mission at MyPaths.com is to provide resources and firsthand accounts of how others found their paths in life, so you can do the same.
Impact Venture Capital & GROCO’s “Venture Vision” Seminar 2 of 6 (To register FREE, click here.) This free online instructional seminar on January 11, 2023, at 10 AM is an excellent opportunity to learn more about the risks and rewards associated with venture capital (VC) investments. By covering topics such as the stages of funding,…
Introduction: In this interview, Alan Olsen, CPA and featured guest Bill Gombert discuss comprehensive financial planning and much more. Transcript: Alan Olsen Hi, this is Alan Olsen and welcome to American Dreams. My guest today is Bill Gombert. Bill, welcome to today’s show. Bill Gombert Thank you very much pleasure to be here. Alan Olsen So, Bill, you’re…
Introduction: In this interview, Alan Olsen, CPA and featured guest Brett Kaufman discuss Building Conscious Communities and much more. This Transcript of Alan and Brett’s discussion of conscious community building has been generated by software and may have inaccuracies: Alan Olsen So Brett in our segments here in American Dreams, we talked about pathways of life and things…
Insights Into Venture Capital Investing From Seminar 1 of 6 (To register for seminar 2 of 6 FREE, click here.) “In an era where financial landscapes are constantly being reshaped, it’s crucial for investors to stay ahead of the curve. The Venture Vision Webinar, a joint initiative by GROCO and Impact Venture Capital, recently hosted…