5 Questions To Ask Before Setting Up A Child IRA

Did it thrill you to see your children cash their first paycheck? Do you display that special kind of inner pride knowing your children have that special kind of responsibility that makes employers want to hire them despite their young age?

Then hold on to your seats, it’s about to get a whole lot more exciting.

Children—no matter what their age—can put those hard-earned wages into a Child IRA. In fact, the younger they do so, the more likely these small sums can grow well into seven figures by the time they retire.

You want your children to be better off. Opening a Child IRA for them might be the easiest way to achieve this. Of course, there are other options, and it’s normal to want to know about these.

“Opening accounts for children is emotional,” says Holmes Osborne, Principal at Osborne Global Investors in Santa Monica, California. “It’s not really about financials, it’s about helping the next generation. Any financial advisor can open an account for a child—IRAs, UTMAs, 529s, etc.”

Before you sign the dotted line, however, it’s best to know exactly what you’re getting into. In some ways, Child IRAs, although essentially the same as the IRA you can set up for yourself, present unique challenges. Finding the answers to these 5 questions will help you see how unique those challenges—and opportunities—can be.

#1: Legally, what’s required to establish a Child IRA?

There are a number of hurdles your child will need to overcome in order to be eligible to contribute to a Child IRA. Mary Anne Ehlert, Partner at Forum Financial Management in Lincolnshire, Illinois, says to be sure you speak with someone so you can have “an understanding of custodial rules, income rules, and withdrawal rules” associated with a Child IRA.

For example, your child, as a minor, cannot enter into a contract. A responsible adult will need to sign the paperwork as a representative of the child. What does that mean, exactly?

“Most parents would want to know how they can control the account as the guardian, and how accessible the account is to the minor,” says Nick Coleman of Bonfire Financial RIA in Colorado Springs. “Having a better understanding of when and how custodial accounts can be used by the minor is important for the family to know to make the right decision in setting up a minor account.”

#2: What counts as income?

Unlike other child-oriented savings vehicles (like 529 plans), your child must have earned income to contribute to a Child IRA. That doesn’t mean you (or the grandparents) can’t gift money to put it into a Child IRA. It just means your child needs to have enough earned income to offset that contribution.

Your child can earn qualifying income in several ways. Since you’re overseeing this, you need to think like an employer to make sure you know what to look for.

“It’s important to understand the income reporting requirements for Employee vs. Contractor situations to determine the best way for the child to receive earned income,” says Dr. Gena Jones, CPA and Founder/CEO of Jones Tax Group, Inc. in Flossmoor, Illinois.

Beyond this basic understanding, you’re already familiar with many of the forms your child must have.

“Not much paperwork is required other than proof of earned income such as a W2 or 1099,” says Steven J. Weil, President and Tax Manager at RMS Accounting in Fort Lauderdale, Florida. “We have had children as young as two with earned income from things like modeling for mom, dad or grandpa’s company. Maybe they appear in advertising or as they get older help with mailings, clean up around the office or perform other tasks. It must be legitimate work, and they need to be paid for it.”

#3: What’s the difference between current and future tax savings?

You might think you know this answer already. In fact, if you’re not careful, your accountant might make the same assumptions for your child as are made for you. You can’t allow this to happen.

That’s because there are two different types of IRAs: the traditional IRA allows you to defer current taxes by contributing to an IRA; while the ROTH IRA allows your savings to grow tax-free because you’re paying the current taxes on the income used to contribute to the IRA.

“The advisor has full knowledge of the Child IRA instruments at their disposal and how to properly use them,” says Mark Gibbens, CEO of Erudite Capital in Prairie Village, Kansas.

“Tax-saving strategies and calculations can help determine if your child will benefit more from tax savings now or in the future,” says Jones. “This will ensure you set up the type of Child IRA account that is most beneficial to your child.”

#4: How Does a Child IRA compare to other savings vehicles for children?

The Child IRA is only one of various popular options parents and grandparents have to help children save and invest. You’ll need to know and understand the distinction between these options. Indeed, you may be more familiar with these other options than with the Child IRA.

“Some options may require a child to have earned income to be able to contribute, while other accounts can receive gifts from parents and other family members,” says Coleman. “Furthermore, some accounts require taxes to be paid every year if there is a gain, such as a UTMA, whereas a Child IRA would not have any tax issues unless there is a distribution from the account. An advisor would have to be an expert in the various funding strategies and taxability, and which is going to be the best fit for the client and their needs.”

By knowing all the choices, you can make a more informed decision. “This will expand the toolbox to include alternatives to a Child IRA,” says Jones. “A CPA would be able to provide the best recommendation based on your goals, not based on the limited options you are currently aware of.”

You should also grasp that a Child IRA is not a “set it and forget it” decision. While a Child IRA might make sense for teenagers (and younger), when your children become adults, they may have access to other vehicles that will allow them to save more.

“As your children grow, their priorities change, and it is important as a trusted advisor to understand the changing challenges and opportunities they are facing and help them answer questions they didn’t know they had,” says Coleman. “Many people with children or grandchildren know about 529 college savings accounts, and sometimes even UTMAs, but sharing information about Child IRAs can help them fulfill their needs of providing security and opportunity to their loved ones.”

#5: What are the emotional and educational opportunities presented by setting up a Child IRA?

You’ve heard the term “teachable lesson,” right? Well, the Child IRA is the MOATL (“mother of all teachable lessons”) when it comes to financial literacy, not only for your children but for you too. You’ll find yourself asking introspective, thought-provoking questions in anticipation of speaking to your child.

Some of these, according to Ehlert might be: “What are the key points that my child needs to learn when able?” “What are my talking points when discussing the Child IRA with my child?” “More broadly, what are some family talking points that will encourage family discussions about financial topics in general?”

And you’re not alone in brainstorming these questions. “The advisor should understand not just the quantitative benefits of Child IRAs, but also the qualitative benefits,” says Gibbens. “This requirement should entail the Child IRA specialist understanding not just the IRA as a savings vehicle, but also how it can be used to improve a child’s understanding of financial management.”

Think of the Child IRA as a launching point not just to greater future wealth, but greater financial understanding.

Coleman says, “Many families want to make sure their kids or grandkids will be taken care of and aided in their endeavors. Setting up a funding and investing strategy to help parents get on the right track will help provide more value to their lives, as well as helping provide expertise to finding the right strategy for their family.”

Bonus Question: What experience do your financial providers have with Child IRAs?

As you review these questions, you might be struck by this thought: “How do I know the advice I’m receiving is reliable?”

That’s always a tough question but knowing the person you’re speaking with has hands-on experience is critical.

“Real-world examples of where Child IRAs can and should be used should be required so that the advisor is familiar with when Child IRAs can best be used,” says Gibbens “For instance, there are some circumstances that would be more appropriate to use Child IRAs than others. Child IRA specialists should be tested on how to best apply their knowledge of Child IRAs to specific situations.”

Yes, thanks to the power of compounding, Child IRAs can be virtual perpetual money-making machines. Like any other great opportunity, it’s best not to dive into it without first getting the answers you need to know.