IRAs for Minors: Why, When, and How

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Opening an IRA for your kids can be a smart financial move. In addition to tax savings, you have the flexibility to use the funds for more than just retirement savings.

When can a minor open an IRA?

There are technically no minimum age restrictions to open an IRA. However, in order to contribute to an IRA, you must have earned income.

You can’t contribute more than your earned income for the year even if you’re under the IRA contributions limit. For example, if the current limit is $6,500, but you only had $2,000 in earned income, you can’t contribute more than $2,000.

(Special rules apply for a spousal IRA where one spouse can contribute to an IRA based on the other spouse’s income. These rules are specific to spouses not family members in general.)

So in order to open an IRA, a minor has to be old enough to start working.

What counts as a child’s earned income to open an IRA?

Earned income generally means income from a job. This can range from informal jobs such as mowing lawns for neighbors to official jobs like being a bagger at a grocery store.

(Check out Side Hustles for Teenagers if you’re looking for job ideas.)

Earned income does not include receiving an allowance or other payments for doing household chores. These are considered household contributions even if you’re paying your child.

I’ve seen two aggressive ways to get around the above that I don’t really like but will mention for your research.

  • Theory 1: It’s earned income if I pay my children to make MY bed (instead of theirs). They’re doing work for me not the overall household.
  • Theory 2: It’s earned income if I hire them to do work that I can normally hire someone else to do such as lawn mowing or babysitting.

It seems like most people who push the limits like that are flying under the radar rather than using a loophole the IRS has explicitly approved. So if you try it and get audited, it may not go well.

One thing that you can do is hire your children in your business (if you have one). They’ll have to actually do work, and the amount you pay them needs to be reasonable. (I.e., no maxing out their IRAs for the year if they sweep your floors for an hour.)

You’ll need to issue them a W-2 or 1099 as appropriate. You may also need to withhold taxes.

You’ll also need to look into your state’s child labor laws, unemployment, and worker’s compensation requirements. While hiring your own children is usually exempt from most requirements, you don’t want to miss anything.

How do you prove a minor had qualifying earned income to contribute to an IRA?

The easiest way to show the IRS that a minor had earned income is through the minor’s tax return. Remember that minors have a lower standard deduction than adults and may need to file taxes with as little as $400 in income.

If a minor doesn’t need to file a tax return, keep other proof such as paychecks and work schedules. You don’t need to file this information with the IRS, but the IRS may ask for it in an audit.

Custodial IRAs for Minors Under 18

Just like opening a bank account, minors under 18 can often only open an IRA with a parent or legal guardian on the account. That’s known as a custodial IRA.

You can open a custodial IRA at most major investment brokers and banks. However, some may not offer this option.

With a custodial IRA, the parent can add funds, withdraw money, and select investments. Older teenagers often manage their own accounts with the parent on the account as a legal technicality.

The other usual IRA rules, such as contribution limits and early withdrawal penalties, still apply.

Unlike a joint bank account, the teenager becomes the sole account owner upon reaching the age of majority. That’s 18 in many states but could be as high as 21 depending on state law.

If you want to require your child to use the money for a specific purpose, you may want to look at other options such as a 529 plan or trust.

Can parents contribute to a child’s IRA?

The only limits on a child’s IRA contributions are the earned income rule and the annual IRA contribution limit. It doesn’t matter if the money comes from the child or a parent, grandparent, etc.

For example, if your child earned $2,000 during the year, you might let him or her keep the $2,000 for spending money and fund a custodial IRA with $2,000 of your own money. You might also agree to match what your child saves in an IRA.

One thing to note is that you can’t open multiple IRAs to increase the limit. If your child’s limit is $2,000, you can’t open three IRAs to contribute $6,000.

If you have multiple family members who want to help save for your child’s future, make sure you coordinate with each other. There’s a 6% annual penalty on excess IRA contributions.

Traditional IRAs versus Roth IRAs for Teenagers

A Roth IRA will almost always be the best option for minors. That’s because most minors don’t make enough to have to pay income taxes.

To review,

A traditional IRA…

  • Gives you an immediate tax deduction for your contributions
  • Gets taxed when you take money out
  • Has penalties if you withdraw money before retirement age and don’t have a qualifying reason (more on qualifying reasons below)

A Roth IRA…

  • Invests money you already paid taxes on
  • Has no taxes when you withdraw money in retirement
  • Lets you take out the money you contributed at any time for any reason without taxes or penalties
  • Does have taxes if you take out earnings before retirement age even if you have a qualifying reason
  • Has penalties if you withdraw earnings before retirement age and don’t have a qualifying reason (more on qualifying reasons below)

Let’s break down some of those Roth IRA concepts some more.

Invests money you already paid taxes on

Even though you need to have earned income to contribute to an IRA, you don’t always have to have taxable income. It’s actually common for a minor to earn less than the standard deduction and not have taxable income.

In other words, the minor is in the 0% tax bracket.

If you’re already in the 0% tax bracket, the traditional IRA deduction is worthless. You don’t have any taxes to deduct from.

For example, if you contribute $1,000 to a traditional ira, you reduce your income by $1,000.

  • $1,000 times a 0% tax rate is $0 in tax savings.
  • If you were in the 10% tax bracket, $1,000 times 10% would be a $100 tax savings.
  • If you were in the 12% tax bracket, $1,000 times 12% would be a $120 tax savings.

A Roth IRA always gives you $0 in tax savings now but has more tax benefits later. So you’ll almost never want to use a traditional IRA over a Roth IRA when you don’t owe income taxes.

Withdrawing money before retirement

There are a number of reasons why a young adult might need to withdraw IRA money before retirement. These might include paying for college, buying a car, or buying a house.

As a reminder, withdrawing Roth IRA earnings is generally only tax-free in retirement. Early withdrawals of earnings (but not contributions) from a Roth IRA are subject to taxes.

To make for easy examples, let’s assume that a minor has an IRA with $10,000 in contributions that has grown to $15,000 total. So that’s $5,000 in earnings inside of the IRA.

Qualified Education Expenses

Qualified education expenses are generally exempt from the early IRA withdrawal penalties. They’re not exempt from income taxes on taxable withdrawals.

If you used a traditional IRA, the entire $15,000 is subject to income tax. That will likely be at a 10% or 12% tax rate.

If you used a Roth IRA, you can take out the first $10,000 in contributions without having to pay taxes. You’ll only have to pay income tax on the $5,000 in earnings if you need more than $10,000.

Buying a Car

Buying a car does not qualify for a penalty-free IRA withdrawal.

If you used a traditional IRA, the entire amount you withdraw is subject to a 10% early withdrawal penalty plus income tax.

If you used a Roth IRA, you can still take out the $10,000 in contributions without taxes or penalties. You don’t need a qualifying reason to withdraw Roth IRA contributions.

If you also need the $5,000 in Roth IRA earnings, you’ll owe the 10% penalty plus income taxes only on the $5,000.

Buying a House

First-time homebuyers can withdraw $10,000 from an IRA penalty-free.

If you used a traditional IRA, you’ll still need to pay income taxes on the $10,000. If you withdraw the additional $5,000, you’ll pay the 10% penalty plus income taxes on the $5,000.

Withdrawing Roth IRA contributions does not count towards the $10,000 home-buying limit.

So you can take out your full $10,000 in contributions plus $5,000 in earnings without penalties. Penalties would only apply if you took out more than $5,000 in earnings.

The home-buying exception doesn’t exempt you from income taxes, so you would have to pay income taxes on the $5,000 in earnings.

Can you switch from a traditional IRA to a Roth IRA?

Let’s say you started with a traditional IRA and now realize that a Roth IRA makes more sense for you. You’ll probably want to do what’s called a Roth IRA conversion.

With a Roth conversion, you change all or part of your traditional IRA to a Roth IRA.

In order to make the change, you pay your regular income tax rate on the amount you convert. Remember, for a minor, this can often be 0%.

Money you convert to a Roth IRA follows special rules. If you withdraw funds from a Roth conversion within five years, you’ll have to pay a 10% penalty on that withdrawal unless you qualify for a penalty exception.

After five years, conversions are treated like regular Roth IRA contributions and can be taken out without taxes or penalties.

How should you invest in a child’s IRA?

Like all investments, you should think about when and how you plan to use the money.

Most retirement savings calculators will tell you to invest in either all stocks or an aggressive target date retirement fund. Those are common recommendations if the money is definitely for retirement savings.

However, if you might use the money for college, a down payment, or other reasons, it might make sense to invest more conservatively. This might include a mixed stock and bond portfolio, money market funds, or bank certificates of deposit.

Talk to a financial advisor about choosing the right investment strategy for your goals. Online robo-advisors may also be able to offer the guidance you need.

Top Questions About Opening a Roth IRA for Kids

Here are some more things you might want to think about when opening a traditional or Roth IRA for a minor.

Why not just use a savings account?

There are several advantages to maxing out a Roth IRA before using a savings account.

You can only contribute so much to a tax-advantaged retirement account each year. So let’s say that you put $10,000 into a savings account over a few years when you could have been contributing to a Roth IRA.

If you need the $10,000 within a few years, it doesn’t make a difference either way.

But if you don’t need the $10,000, you can’t just put it into an IRA. There’s a $6,500 annual limit, plus you may want to contribute new money. Once you start working, you may be above the income limits for a Roth IRA or deductible IRA.

So in some cases, it’s now or never. Any Roth contributions you skip are lost forever.

In addition, a Roth IRA offers tax-free growth. With a savings account or bank CD, you have to pay taxes on the interest you earn each year.

Finally, using a Roth IRA doesn’t mean risking money. You can open an FDIC-insured savings account that’s classified as a Roth IRA but has the same interest rate as a regular savings account.

Do contributions to a kid’s Roth IRA count for the Saver’s Credit?

In order to qualify for the Saver’s Credit, you must be 18 or older. In addition, you can’t be claimed as a dependent on someone’s tax return or be a full-time student for at least five months of the year.

A parent also can’t claim the Saver’s Credit for contributions to a minor’s custodial account, because the contribution counts for the minor not the parent.

Does having an IRA affect financial aid?

IRAs and other retirement accounts don’t classify as assets for FAFSA and most financial aid purposes. Taking money out of an IRA could affect either your assets or your income.

Is contributing to an IRA for your kids subject to gift tax?

It’s impossible to owe gift tax on IRA contributions alone. That’s because the IRA contribution limits are lower than the annual gift tax limits.

However, you should review the gift tax rules if you give any one person more than $17,000 during the year.

Can you give your own IRA to your child?

It’s generally not possible to transfer your IRA to another person while you’re alive. (The main exception is transferring your IRA to your spouse as part of your divorce agreement.)

If you don’t plan to use your IRA money, you can name your children as beneficiaries or leave your IRA to them in your will.

There are ways you can use your IRA money to help your children.

In most cases, you can use the qualified education expenses exception to take money out of your IRA to pay education expenses for your child, grandchild, or spouse. You’ll need to be able to show receipts for specific, qualified expenses.

Just giving your child money while he or she is in college doesn’t count. You also can’t transfer IRA money to a 529 plan.

You’re also usually allowed to use the first-time home-buying rule to use IRA money to help a child or grandchild with a down payment or closing costs.

However, you can only take out $10,000 total over your lifetime covering both your own home purchase and any assistance you give your children. It’s not $10,000 per home purchase.

If you take money out of your IRA for other reasons, it will follow the regular IRA withdrawal rules. The potential taxes and penalties will depend on your age, the type of IRA, and whether you’re making a qualified distribution.

Is it really worth it to invest in an IRA at a young age?

Yes, it’s almost always a good idea to start investing early once you have other needs covered.

$5,000 invested today at a 9% annual return (about average for the stock market) over 40 years will turn into $157,047.10 without adding any other money. That’s a very nice jump start on retirement planning.