Academic journal article Academy of Accounting and Financial Studies Journal

Kid IRAs: Ensuring a Secure Financial Future for Your Children

Academic journal article Academy of Accounting and Financial Studies Journal

Kid IRAs: Ensuring a Secure Financial Future for Your Children

Article excerpt

INTRODUCTION

The IRA playing field has expanded. Traditional IRAs for children have been rare since children seldom have sufficient income to benefit from a tax deduction. However, a Roth IRA for a child can be very attractive, as discussed in this study. Hebert (2008) notes that if a minor child has earnings from a job, the parent would be wise to open a Roth IRA on behalf of the child. He further emphasizes that, like adults, children can make a Roth contribution of up to $5,000 or 100 percent of their earned income, whichever is less.

Many IRA providers, in fact, will establish an account for a minor. A minimum age is not required to establish a traditional or Roth IRA. Rather, to open a "kid" IRA a child must have taxable compensation income and an IRA provider who will establish an account.

Several advantages become evident in opening a kid IRA. One advantage is the tax-free compounding of earnings on the investment inside the IRA, which has a powerful multiplying effect on the investment account. This accumulation becomes greater when the savings begin during childhood. When tax-free deposits or tax-free accumulations have more than 50 years to compound, a modest savings plan can produce substantial wealth. There is no minimum age to establish an IRA, and in the case of a Roth IRA, there is no maximum age to establish the account. Finding providers willing to establish a kid IRA takes some effort, however. Some providers will not establish a kid IRA or will establish one only under very restrictive conditions--due to liability concerns rather than tax restrictions.

Another positive aspect of a kid IRA is the flexibility provided for depositing funds in this type of IRA. When a child earns money, the physical dollars are not required to be deposited; a parent may provide the funds to establish the IRA, limited to the actual earnings of the minor in a particular year.

The money and control of asset selection in an IRA belongs to the individual; the child owns his or her IRA. The child may choose to withdraw the investment, although the minor may need to wait until the age of majority to do so.

FINANCIAL MOTIVATION

By teaching children to invest as soon as income is earned, parents can help their children see the financial implications as IRA deposits accumulate over time. Examples shown in Table 1, Panel A, should provide encouragement to start an investing program. Table 1, Panel A illustrates the outcome of investing a single investment of $4,000, given the 2007 limit (CUNA Mutual Group Service, 2008), while Table 1, Panel B, shows the financial effect of the initial $4,000 investment with $4,000 additional investment on each subsequent birthday.

Using Ibbotson's historical rates of return (Ibbotson, 2000) and an investment horizon of 50 years, this $4,000 is expected to grow to $1,510,008 (see "Small Company Stocks" in Table 1, Panel A). With additional yearly deposits of $4,000, the results are much more dramatic yielding $13,462,461 (see "Small Company Stocks" in Table 1, Panel B). If early investments of $4,000 are unrealistic for a young child or teenager, subsequent investments of $4,000 in later years will still have a great impact on the accumulated earnings. The goal should be to develop early habits of saving to secure financial independence.

A child typically pays little or no taxes so the tax deductibility of a deposit to a traditional IRA represents very little benefit. Yet, the impact of this deposit is even greater if the investment is sheltered in a Roth IRA, since the deposit is made after-tax but the distributions are received tax-free.

SURVEY DESIGN

Mutual fund families in this study were identified in the annual list of "The Best Fund Families" (Norton, 2000), compiled by Barron's/Lipper. To qualify for the Barron's/Lipper rankings, a fund family had to offer investors a full range of options. …

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