IRAs for Kids: It's Never Too Soon

Opening an account early can give them valuable lessons in finance, as well as a head start on saving for retirement

by Ellen Hoffman

What's the best age to start saving for retirement? A common answer is when you start your first "real" job and can sign up for a 401(k) or other plan offered by your employer.

But often children are working long before that. If their parents encouraged it, probably even more young people would do appropriate work, such as babysitting or dog-walking, for pay. And that's all it takes to do what may be the best way to help your kids get a head start on retirement savings: Put some or all of their earnings into an IRA.

The demise of traditional pension plans, uncertainties about the future of Social Security, and the increasing reliance on 401(k)-type plans to finance retirement are all good reasons to expose your children to the idea of retirement savings at an early age, many financial experts agree. What's more, with the potential of 50 years of compounding returns, even a modest amount of money in an IRA now can turn into very big bucks.

Record-Keeping Is a Must

Eligibility to make IRA contributions requires having income from work rather than from gifts or inheritances. The work can be for other people, such as your neighbors, or for your own business. If you're self-employed or have a small business, you can hire and pay your children, claim a deduction on your business taxes, and insist that the children put their earnings into an IRA.

It's important that you keep detailed records. Financial planners I spoke to said if you're basically having your own child do chores in return for an allowance, don't try this. If your child is working for others, then keep a log of dates, the type of work, and the employer.

Steven Podnos, a physician and financial planner in Merritt Island, Fla., opened IRAs for his three children "as soon as they were old enough to reasonably do things for my business, when they were around 12 years old." They've done secretarial work, filing, computer maintenance, and phone calls. Now, 20-year-old Rachel, a college sophomore, has about $50,000, high-school senior Lauren has about $36,000, and high-school junior Jake has around $14,000. Podnos was able to persuade his children to save by showing them how their money could grow. He says the older two kids understand, but he's not sure the youngest "gets it" yet.

Convincing Kids

Cheryl Costa, a financial planner in Natick, Mass., pays her sons, Matthew, 14, and Eric, 12, to help stuff envelopes for her firm's quarterly newsletter mailings. The boys are only earning about $200 or $300 a year right now, but she opened accounts for them about two years ago because, "I realize what a powerful tool Roth IRAs are for building retirement savings." To try to convince her kids, "I make a spreadsheet and show them" how much money they could save, she says.

Costa estimates that her 14-year-old's current account of $1,500 could grow to about $78,000 at an 8% return over the next 51 years, or more than $193,000 if the return were 10%—and that's without adding any money to the account.

If your children insist that they'd rather use their earnings for video games and Roller Blades instead of retirement, try this: Open the IRA with their earnings and then give them a gift equal to what they invested. That way, they'll have money to spend and perhaps, over time, they'll be impressed at how the IRA account grows and decide to keep on contributing. (The IRS doesn't require you to report gifts as long as they're under $12,000.)

Aggressive Is O.K.

Costa chose Roth IRAs for her boys because although income tax must be paid on contributions, when the money's withdrawn there will be no tax. And at the boys' low income level, they won't owe tax now anyway. If she had chosen a traditional IRA instead, Matt and Eric would have to pay income tax on it when they withdrew the money.

So what does it take to set up the account? The child is eligible to deposit some or all of his earnings, up to $4,000 per year, in the IRA. You set up the account using your child's Social Security Number with a financial-services company. You may need to shop around.