Putting off immediate gratification for a delayed reward is a great lesson for any child. My now 11 and 13-year-old kids have had savings accounts since they were 3. Going down to the bank to deposit their hard-earned allowances gives them a sense of joy and pride. But if possible, most parents should eventually move from saving to investing. If your child is lucky enough to have earned income, the best account for this is the Roth IRA.
4 reasons your child should have a Roth IRA:
Roth Reason #1
Investing beats saving (over the long term). Compounding is magical with any account type but when you add in the higher return potential of investing, the magic is even more spellbinding. Roth IRAs have the potential to hold investments; savings accounts do not. If you consider inflation, investing is more advantageous. A child’s long-time horizon is ideal for investing and the tax-free qualified distributions in retirement will add to the child’s financial security.
How compounding and inflation might look after 50 years:
Roth Reason #2
A higher tax rate in retirement. One of the debates of post-tax Roth accounts vs. pre-tax Traditional accounts is the uncertainty of whether your retirement tax rate will be higher than your current tax rate. It is a factor in deciding whether it is better to take the tax-deduction now or tax-free funds in retirement. Long-time horizons and low current tax rates are perfect for the Roth, and children have both of these.
If in doubt, please see your tax pro to see how earned income might affect your child’s specific tax situation.
Roth Reason #3
It is a multi-purpose account and college financial aid. One of the main reasons the Roth is considered a multi-purpose account is that contributions are available anytime cash and penalty free. This feature makes it great for a college fund or an emergency fund (just be careful how you invest). Earnings will be taxed as ordinary income and will also have a 10% penalty if withdrawn before age 59.5. Also, the Roth and Traditional IRAs both have a higher-education feature that includes no penalty on earnings. The earnings will be taxed as ordinary income, but still a nice feature.
As though the Roth wasn’t attractive enough, it is also not viewed as available college-funding assets for most college financial aid calculations, except when contributions or earnings are distributed. Most colleges use the Free Application for Federal Student Aid, or FAFSA. Retirement accounts like the Roth are not taken into account in the financial aid calculation. This applies to both the student and parent. Ignored assets or income means more potential financial aid!
Roth Reason #4
Skin in the game and they will thank you. Children will work harder and get more excited if they have skin in the game. If the child knows they are benefiting from the investment, they will try to learn more and see the correlation between sacrifice and risk and reward. Your child will also thank you for your guidance. Kids don’t always have the perspective to think long-term. You giving your child this perspective will benefit them for a lifetime. Most younger financially successful 20-somethings credit lessons taught to them by their parents for their success.
What will you need to open a Roth?
Your child needs earned income to open any IRA, including a Roth. Earned income is just like it sounds: getting paid for working (participating) in a business or trade. The income can’t come from investments, interest, or dividends. A gift is not considered earned income. The earned income from a “normal” employer is the easiest to use. Not only is there little chance the IRS would question the legitimacy of the W-2 income, but the employer would handle the paperwork and the FICA (Social Security and Medicare) tax withholding.
If you, the parents, own your own business, it can be relatively easy to document the duties and the pay. You may also have experience with the 1099 or W-2 paperwork and tax withholding and reporting.
If however, you don’t have your own business, it can get a little trickier staying on the right side of the IRS. Generally speaking, day-to-day allowance type work does not qualify as earned income. Specific tasks like babysitting and helping with a house remodel would most likely qualify. The child may also be responsible for the self-employment and income tax payments. There are many different rules around when you must file a tax return, but the main one applicable to most self-employed children is that if they had NET earnings greater than or equal to $400 for 2018, they must file (notice the key word “net”).
Most financial institutions will not open a Roth for a child by themselves. A parent or adult will need to be the custodian. The three firms I like to use are E*TRADE, Schwab, and TD Ameritrade. All three have low costs and low account minimums. You don’t want fees to eat up your child’s hard-earned investment.
If there are too many fees, especially with smaller-balanced accounts, the account can’t grow. Ideally, the only two fees should be an expense ratio and a one-time trading fee. The expense ratio should be well below 0.75% and the trading fee should be no more than $25. Given the low cost of brokerage compared to when I started twenty years ago, there should really be no other fees for the account.
An Investment Approach
(Investment Policy Statement)
When investing for a child, a simple, diversified, low-cost approach is probably best. This usually means using one broad-based passive index, or index-type mutual fund or ETF. The goal should be to take advantage of long-term U.S. and/or global growth, not to time the market or stock pick.
Helping your child set up a Roth and teaching them the basics of finance and investing can take a little bit of prep work, but the long-term return on your time investment will be greater than you can imagine.