YOUR FINANCIAL FUTURE

An IRA is a Terrific Way to Invest in Your Child’s Future

In my last two articles I wrote about being a financial role model for your children as well as how to teach them in an age appropriate manner to handle money wisely. To go one step further, let’s look at the benefit of encouraging a child who has earned income to establish an IRA.

Traditional IRAs offer a tax-deduction and the tax-deferred growth of money. Distributions are taxed as ordinary income, usually at retirement. They have a 10% penalty on most distributions before age 59 years. They aren’t the best option for most children as their income is usually not high enough to warrant a tax deduction.

Roth IRAs make great sense; they are designed to use after-tax savings rather than tax-deductible funds. Significantly, they allow for the tax-free growth of the money. That’s right, the savings will compound over time and they can be withdrawn tax and penalty-free at retirement as long as the account has been open for 5 years!

Let’s look at how money could compound in an IRA. A one-time contribution to an IRA of $1,000 at age 10 that earns 7% annually would be worth $29,457 after 50 years. Should your child contribute $50 per month on top of the initial $1,000, at age 60 she would have $282,527. If we double her contribution to $100 per month, her balance at 60 would be $535,598. Just imagine how much greater her account would be if she made greater contributions during her working years!

As I mentioned above, the IRA contribution has to be from earned income. Allowances, inheritance and investment income do not count and may not be used to make contributions. Contributions could be from babysitting, dog walking, or entrepreneurial activities. Many of these employers do not provide a W-2 statement at year end, so it is incumbent on you or your child to document the name of the employer, the type of work completed, the dates and the income received.

Should you own a business and employ your child, they can perform age-appropriate work and receive reasonable compensation. This can be a win-win situation in that your child receives income and your business receives a tax-deduction. Don’t forget that they should receive a W-2 statement from your business at year end.

While the maximum IRA contribution in 2015 is $5,500, the maximum is restricted to the amount of income earned. So if your child earned $2,000 this year, she is restricted to a $2,000 contribution.

You may wish to match her contribution, that is let her spend her $2,000 and you make the contribution for her. Or match it 50%; so she would save $1,000 and you add an additional $1,000. The IRS won’t care who writes the check as long as the amount contributed does not exceed the amount earned.

Most banks, mutual fund and brokerage companies will allow you to open a custodial IRA for your child. You are the custodian for the account and control the assets until age 18 in Florida (19 or 21 in some states) when your child will then own the account.

One last benefit of an IRA is the ability to use the funds for higher education expenses and up to $10,000 for the down payment on a first home without incurring a penalty. Note, the earnings in a Roth IRA may be taxed if the account is less than 5 years old; the distribution from a traditional IRA will be taxed as ordinary income.

While most children are not thinking about retirement, they may be excited to learn about the compounding of money. That is, how a small amount of money can grow to a huge amount of money later. IRA’s can provide a terrific learning activity for them; they have an opportunity to learn about different types of savings and investment accounts, interest and capital gains. They can also acquire knowledge about dollar-cost-averaging into an investment account.

Review the statements together and watch the money grow!

Roxanne E. Fleszar, CFP, ChFC is President of Financial Resources Management Corp, a registered investment advisory firm with offices in Key West, Boston and Naples

 

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