Almost every client we talk to wishes they began saving for retirement sooner. Since you can’t turn back the clock, why not improve your child, or even grandchild’s, prospects for building adequate retirement savings? What better way to teach them about money, responsibility, and the benefit of compound interest than opening them an IRA, or an Individual Retirement Account.

A study showed that 62% of grandparents give their grandchildren some sort of monetary gift yearly. While giving a teenager, for example, a $1,000 gift seems like a huge amount today, more value can be given to this money, not only in terms of compounding interest but also the financial lessons that come along with it. Say you put this $1,000 in an IRA for your 16-year-old grandchild. With an assumed 7% interest rate, this account will grow to over $25,000 by the time they are 65 years old. Say after you put in the initial $1,000, you continued to put in a $1,000 a year until they take over and continue this yearly contribution. This account would have over $430,000 when they are 65. That is a great start to retirement savings, even if they do not keep up the full contributions.  

There are some limits to how much money you can give your grandchild for an IRA. The first limitation is that there is a yearly $6,000 limit in 2019 for IRA contributions; putting in more than this comes with penalties. The second limitation is going to come from how much income your grandchild is bringing in. You are only allowed to contribute as much money to an IRA as your taxable compensation for the year. Therefore, if your grandchild made $1,000 this year, that is the max amount allowed to be put into the account. If your grandchild has a traditional job, their W-2 will indicate their income. If they have odd jobs, such as babysitting or lawn care, they will need to keep receipts of this work and file a tax return with the IRS to have proof of earned income and be eligible for an IRA.

So you determine your grandchild has the yearly income and you want to open an IRA for them, what now? To start, there are two different types of IRAs: Roth and Traditional. Taxes are really the only difference between the two. With a traditional IRA, you pay taxes when the money gets withdrawn, which makes contributions tax-deductible in the year they are made. Roth IRAs allow for tax-free withdrawals, but the money put into the account is not tax-deductible. When starting an IRA for your grandchild, you will need to pick one or the other.

A Roth is typically used for this purpose due to the tax-free withdrawals. Issues can arise though once the grandchild reaches the age of majority, which is 18 in most states, and they can take full control of the account. Due to the post-tax money going into a Roth, it is much easier to withdraw the money in the account without penalties or tax, even if it is before age 59 ½ . Also, while rare, if your child has too large of an AGI ($122,000 in 2019), you will not be able to open a Roth account for them.  

On the other hand, one advantage of a Roth is that the grandchild can use the account as a potential emergency fund. While this will hurt its compounding, it could be useful in a time of need. In this case, your grandchild can take out all the initial contributions tax and penalty free. If they take out the earned interest though, it will fall under the rules of a withdrawal from a traditional IRA, which would mean a 10% additional tax on the money, unless it qualifies for one of these exceptions.  

The advantages to opening a traditional IRA is limited, due to the fact that the contributor (parent or grandparent) can not take a tax deduction for this and the child on the account will only be able to take a tax deduction if their income surpasses $12,000 in 2019. The disadvantage is that the money in the account will be taxes when the grandchild does start withdrawals, usually at a higher tax rate than they are currently paying.

Once you pick a Roth or traditional IRA, the logistics of opening an account can be a little tricky.  Varying by state and firm where you open the account, the child’s legal guardian might have to be the custodian on the account. This means if you are a grandparent, you would need to coordinate with the parents. To open the account, you need your grandchild’s name, address, date of birth, Social Security number, and their earned income.

It is never too early to start planning for retirement. Encouraging your grandchildren to use their own income to make regular deposits as well as continuing the discussions of how they should handle the IRA in the future will leave your grandchild with a gift for the rest of their life as well as yours.

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