Individual retirement accounts offer a means of setting aside a portion of your earned income in a tax advantaged account for your retirement years. There is no minimum age for setting up or contributing to an IRA, and the power of compound interest combined with tax-deferral makes starting early a great idea. However, since a child cannot legally establish bank accounts, an adult must set it up for them, eventually allowing them to take over the account in adulthood.
You can help your grandchildren establish a secure future by opening a IRA for them, but the account must meet the government's requirements. Here's what you should know about choosing an IRA and contributing to it.
Requirement of Earned Income
Individual retirement accounts function differently than traditional bank savings accounts, or even investment brokerage accounts. Minors are allowed to set up and contribute to an individual retirement account regardless of their age. The primary requirement is that they have earned income.
The "equal to" factor is important, because there is no requirement for your grandchild to contribute the actual funds she earned to her IRA. You can contribute an amount equal to what she earned, up to the limits prescribed by law, into her IRA account even if she spent the money she earned on clothes or video games.
Using a Traditional IRA
You can set up a traditional individual retirement account for your grandchild. Your grandchild will be able to deduct contributions from her income when she files her federal income tax return and the funds in her IRA will grow tax-deferred until she withdraws them.
A traditional IRA may not provide the greatest level of benefits for your grandchild. Children are traditionally in a lower tax bracket than they will be in when they retire, so the benefit of the initial tax deduction will be offset by the taxes that will be due once she starts taking withdrawals after she reaches retirement age.
Choosing a Roth IRA
You can set up a Roth individual retirement account for your grandchild. Your grandchild will not be able to deduct contributions from her income when she files her federal income tax return, but the funds in her IRA will grow tax-deferred until she withdraws them. If she leaves the funds in her Roth IRA until she reaches retirement age, which is 59 1/2 years as of the time of publication, all withdrawals from her Roth IRA will be completely tax free.
Considerations for Grandchild's IRA
You cannot make any contributions to your grandchild's IRA that exceed her earned income for the tax year. The income your grandchild earns must be bonafide earned income. It cannot come from an allowance given for performing household chores. For example, if you have a family business and the child is performing age-appropriate (look up child labor laws) tasks for the business, they have established earned income.
The funds in your grandchild's IRA belong to her, not you. She has the right to withdraw those funds at any time for any reason, although she will have to pay income taxes plus a hefty tax penalty if she makes a non-qualified withdrawal. It's important to note that you are not allowed to take a tax deduction for any contributions you make to your grandchild's IRA.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.