all about How To : How to Make Kids Rich by Investing in an IRA

How to Make Kids Rich by Investing in an IRA A little-known benefit of an IRA (Individual Retirement Arrangement) is that kids can have them too—if parents follow some simple rules. Setting Junior up with an IRA is a smart way to provide a head start to pay for retirement or even a college education.

In this post, I’ll explain the benefits of starting an IRA for minors, the rules for eligibility, how to open an account, and when you can spend the money penalty free.

Free Resource: Retirement Account Comparison Chart (PDF download) - get this handy, one-page resource to understand the different types of retirement accounts.

If you want to help your child supercharge building his or her own wealth and learn the fundamentals of investing, you can’t beat an IRA. You can open and manage the account on his or her behalf until they become an adult.

Imagine you help your child put $500 in an IRA every year from age 15 to 20. Even if he or she never contributes another penny to the account, at age 65, assuming an 8% average annual return, the account would be worth about $95,000.

But if your child continued making annual contributions of $500 every year from age 20 to 65, his or her IRA would be worth over $285,000. Kick those contributions up to $1,000 per year and there’d be close to $575,000 in the account. Try $5,000 a year and the account would have almost $3 million!

But if you don’t get started until middle age and only have 20 years before retirement, you’d have to invest $12,500 per year to accumulate $575,000. The more time your money can grow, the easier it is to build wealth.

Even putting away small amounts over a long period of time can make you quite wealthy. Investing just $125 a month for 50 years at an 8% average return would give you $1 million to spend in retirement.

If parents have a little foresight, they put a child on the right path by showing them that when you make investing a habit it’s easy to create financial independence.

Who Can Have an IRA?

Many people don’t realize that kids can have a retirement account. You can make contributions to an IRA when you (or your spouse if you file a joint return) receive taxable compensation during the year. With a traditional IRA, the only restriction is that you can’t contribute after age 70½.

Roth IRAs don’t have an age limit, but they do come with income limits that prohibit people with high incomes from contributing. Unless you’re raising the next Mark Zuckerberg, your child isn’t likely to cap out the earnings threshold. This is one of the reasons why a Roth IRA is a great savings vehicle for kids. I’ll tell you more about their benefits in a moment.

So, if a child earned money during the tax year, you or your child can contribute as much as he or she made, up to the annual limit, which is currently $5,500. But the tricky part about IRAs for minors is that their earned income must be documented.

That means you can’t fund an IRA for an infant or toddler who can’t legitimately earn income. You can’t pay an 8-year-old a cash allowance for household chores and call it income for the purposes of an IRA without proper documentation. Additionally, you can’t pay kids an outrageous rate, like giving your teen $1,000 to wash your car, and then put it in an IRA.

What Types of Income Qualify for Kids for an IRA?

So, let cover exactly how parents or older kids can comply with the IRS rules for having an IRA. First, they must earn an allowable type of income:

wages
tips
commissions
scholarship payments
self-employment income

It’s great if they earn money in other ways, like income from non-retirement investments or interest, but those don’t count for the purposes of an IRA.

Older kids may have a part-time job during the school year or full-time work during the summer. If they receive a paycheck with taxes deducted, that makes it easy to document earnings.

At the end of the year, employers issue Form W-2 and the amount shown in box 1 is the amount you can contribute to an IRA. Scholarships and fellowship payments are also considered compensation for IRA purposes, if they are shown in box 1 on a W-2.

Let’s say your daughter earned $3,000 working as a summer lifeguard for the local country club. That makes her eligible to contribute $3,000 to an IRA for that tax year. But if your son earns $6,000 as a bus boy, he could only contribute the maximum of $5,500. And in years when a child has no earnings, no contributions can be made to an IRA.

How Kids (or Their Parents) Claim Self-Employment Income for an IRA

But what about kids who receive a Form 1099 at the end of the year or who get paid in cash for services like mowing lawns, babysitting, or dog walking? I mentioned that self-employment income does qualify minors for an IRA.

For a child’s self-employment income to count toward IRA eligibility, you or your child must file an annual tax return.

Kids or adults who earn income on their own, with no formal business structure in place, are called sole proprietors. A sole proprietorship is the default business type that most people use when starting out, but you can use it forever.

A sole proprietorship is owned and run by one person and there’s no legal distinction between the owner and the business. The business name can be the same as your child’s name or you can choose a different trade name if you like.

For a child’s self-employment income to count toward IRA eligibility, you or your child must file an annual tax return. You’ll use Schedule C or Schedule C-EZ to report the income and any related expenses for your child’s business as a sole proprietor.

His or her net amount of income or loss gets entered on Form 1040, U.S. Individual Income Tax Return. And no matter your age, if your business earns $400 or more, you must also pay the self-employment tax, which covers Social Security and Medicare, using Schedule SE.

If you pay a child for doing work like babysitting, doing errands, or shoveling show, and want to claim it as his or her business income, keep detailed records. Maintain a log or spreadsheet that lists the date, type of work, and the amount paid to the child so there’s no question about the legitimacy of the income.

Even though your child must have earned income to justify IRA contributions, what gets deposited into the account doesn’t have to come from his or her money. In other words, it doesn’t matter where the money for a kid’s IRA contribution comes from as long as it doesn’t exceed the amount your child earned during the tax year.

Also, IRA contributions can be made at any time during the tax year up to the following April 15. You could set up a rule that contributions can only come from your child’s earnings each week or month.

Or you could implement a matching program where the child gets to keep all or a portion of their income and then you make contributions on his or her behalf with your own money. This sets a great example for kids and shows them that you value saving for the future.

Even though your child must have earned income to justify IRA contributions, what gets deposited into the account doesn’t have to come from his or her money.

How to Open an IRA for Your Kid

An IRA for a minor is known as a custodial IRA or a guardian IRA and is easy to open at most major banks, brokerages, and investing companies like Betterment, Scottrade, and USAA.

The account will be in your son or daughter’s name, but you or another adult will manage it until your child turns 18, or 21 in some states. Just like with a regular IRA, the financial institution may require a minimum amount to get started, such as $50 or $100.

You’ll typically have the choice to open either a traditional or a Roth IRA for your child. With a traditional IRA, you don’t pay tax on contributions or growth in the account until you take withdrawals in retirement. At that time, you’ll pay ordinary income tax at whatever rate the IRS requires for your level of income.

With a Roth IRA, you do pay tax on contributions to the account. However, all withdrawals in retirement are completely tax free. So, a Roth favors low-earners, like kids, who will have more income and a higher tax rate in the future.

Kids typically don’t earn enough to benefit from the up-front tax deduction that comes with a traditional IRA. So, the Roth IRA is the best choice for minors from a tax perspective.

How to Choose Investments for a Kid’s IRA

After you open an IRA, you need to choose the investments to own inside it. Many firms offer a dizzying array of options including stocks, bonds, CDs, mutual funds, exchange-traded funds (ETF).

Don’t get bogged down by the choices. Stay focused on the objective for a young investor: long-term growth. This means most or all of a kid’s IRA should be invested in some form of stocks, also known as equities. I don’t recommend buying individual stocks, but would steer you toward a stock mutual fund or stock ETF.

I won’t go into the differences here, but what you need to know is that both mutual funds and ETFs are investment vehicles made up of hundreds or thousands of individual investments. That makes them much more diversified and less risky than owning just one or two individual stocks.

Stay focused on the objective for a young investor: long-term growth. This means most or all of a kid’s IRA should be invested in some form of stocks, also known as equities.

How to Spend Money in an IRA Without a Penalty

In addition to the top-notch tax breaks that come with a Roth IRA, they give kids (and adults) even more benefits. Namely that after you’ve owned the account for 5 years you can withdraw funds that were previously taxed (your contributions) without having to pay any additional tax or penalties before reaching age 59½.

Since earnings in a Roth IRA haven’t been taxed, withdrawing them typically triggers income tax plus an additional 10% penalty, if you haven’t reached the age of 59½. However, one exception to the rule is when you use them to pay for qualified education expenses.

This means your child’s money isn’t locked up and only for retirement. A Roth IRA is one of the most flexible types of retirement accounts because you can tap all or some amount of it without penalty to pay for education, a car, house, travel, or anything your child wants.

Of course, it’s always better not to make withdrawals so the account mushrooms into those impressive numbers that I previously mentioned. Even though saving for retirement income is probably the last thing on a young child’s mind, showing them how small investments can turn into huge numbers later may help them stay motivated to build wealth for the future.

The Benefits of IRAs for Kids

Setting up your child with an IRA is an underutilized benefit that gives him or her an amazing financial head start. Even having a small IRA serves as a platform to discuss the benefits of earning, saving, and investing for long-term growth.

The earlier you instill the importance of making saving a habit, the better off your child’s finances will be for life. Getting them comfortable with the lingo, concepts, and account options early in their development gives them valuable skills to take into adulthood.

Young investors have a tremendous mathematical advantage when they leverage the power of compounding to build wealth. Plus, with a Roth IRA they have flexibility to tap the account early if absolutely needed.

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all about How To

Rabu, 12 April 2017

How to Make Kids Rich by Investing in an IRA