The Case for Getting Your Child a Retirement Account

They say it’s never too early to start saving for retirement. How about birth?

Take a parent who invests $7,000 in the stock market for a baby born today. Assuming a standard 7% rate of return and no or very low management fees, that initial investment would be worth well over $569,000 by the time the child hits retirement age at 65 without anyone making a single additional contribution.

The power time brings to a portfolio is one of the reasons I felt this query from a subscriber a few days ago was so compelling:

Interested to hear your take on custodial Roths. My daughter is 11 and I’m thinking about opening one for her. Are there better tools to start her on building wealth for her financial future?

The reader added that her daughter already has a 529 college-savings plan that is on track and wondered if a retirement account might also help teach her about finance.

Minors can have a few different kinds of retirement accounts, and custodial Roth IRAs are a popular option. Parents can’t just make a contribution like an allowance or gift. The money must be the child’s earned income from a job like babysitting, tutoring or even social media work. However, contributions grow tax free and withdrawals in retirement aren’t taxed.

Sounds pretty good, right? Tax-free growth that has decades to compound? But are such accounts right for our subscriber? Are they right for the children in your life? I interviewed four financial advisers across the US, and here’s what I found out:

Consider custodial Roths as just one part of an account mix

The most helpful thing I heard this week was that your child could benefit from not one, but multiple investment accounts. Custodial Roths may be a good fit for children who have jobs — but not for those who are still too young for employment. This makes it seem unlikely but not impossible our reader’s 11 year old could benefit from a custodial Roth. However, several financial advisers I spoke with talked about parents with their own businesses who are able to pay their children for legitimate work, such as modeling, sometimes starting in infancy.

“Just like you diversify your portfolio, you also want to diversify your vehicles,” Alvina Lo, chief wealth strategist at Wilmington Trust in New York, told me. Lo, herself, recently opened a custodial Roth for her 16-year-old son after he got a job working at a concession stand at a local pool. But she recommends people think holistically about the tax benefits they’re getting from all of their family’s account types.

What else is out there?

Our subscriber mentioned she has a 529 plan, but they are worth mentioning for all of our readers because they offer similar advantages to a custodial Roth without the earned income requirement. In many states, investors who make use of 529 plans get state income-tax deductions, tax-deferred growth and tax-free dispersals, if the funds are eventually used on education.

Some parents worry about contributing to 529 plans in the event their children don’t go to college, said Edward Jastrem, chief planning officer at Heritage Financial in Westwood, Massachusetts. But he addedrecent changes have made them a bit more flexible. Now, beneficiaries with money remaining in 529s can roll some leftover funds into a Roth IRA without paying the usual 10% penalty for withdrawing for non-education expenses. But there are limits. The 529 account must be at least 15 years old and there is a $35,000 lifetime limit on transfers.

That’s a major caveat, which may make another set of custodial accounts more attractive. Those are Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts. Ugly acronyms aside, these are basically taxable investment accounts for kids that aren’t tied to either education or retirement. They’re simple to use, and there are no contribution limits. But tread carefully.

“When it comes time for college and financial aid, those accounts are considered in your child's name and they ding you for financial aid,” Catherine Valega of Green Bee Advisory near Boston told me. Aid calculations are complicated, but in general, assets such as a 529 in a parent’s name are factored in less than those in the child’s. Additionally, retirement accounts typically do not affect federal aid calculations.

The bottom line

As you can see, no single option is perfect for or even applicable to every situation. One thing the advisers I spoke with agreed on was that starting a retirement plan of any sort for your child does give them the benefit of time. And doing so creates a good opportunity to start talking about investing and saving. I liked what Jeremy Finger of Riverbend Wealth Management in Myrtle Beach, South Carolina, had to say about getting started early — as long as you’re being smart about rates and debt.

“When people commit to retirement, they’ll eventually find ways to buy the car and go to college and do those other things,” he said. “You can borrow money for a car, you can borrow money for college, but you can’t borrow money for retirement.” — Charlie Wells