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can be withdrawn tax free at any time, for the earnings to get the preferential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.
|