5 Questions to Ask Before Opening an IRA for a Minor
By Jodie Norquist, CIP, CHSP
For many young people, the start of summer brings their first on-the-job experience, followed by their first paycheck. While a summer job can teach the value of money and hard work, it can also be an opportunity for parents to help them get a jumpstart on saving for their retirement. The earlier they begin saving, the greater the potential for them to build a sizable nest egg for retirement. And, if it becomes necessary to tap these funds for higher education, a first home, etc., it may be possible—depending on the type of IRA—for the saver to do so with minimal or even no tax consequences.
You may have clients who ask if they can open an IRA for their minor child. The short answer is yes, their child can have an IRA. There are no minimum age limits on who can own an IRA. But there are some things you’ll need to know before opening an account for a minor.
Does the Minor Have Earned Income?
To contribute to an IRA, everyone, including minors, must have eligible compensation. The IRS defines eligible compensation as taxable income, including wages, salaries, and tips. While children generally must be at least 16 years old to obtain formal employment, there are situations in which a younger child may earn income, such as modeling, acting, or working for a family company. Self-employment income, earned by mowing lawns or babysitting, for example, would be considered eligible compensation if it is reportable to the IRS. But if a minor’s total income is below the federal income tax filing threshold ($12,400 for 2020), no tax return need be filed, even if an IRA contribution is made.
Keep in mind that the minor must have earned enough eligible compensation to support the IRA contribution. For instance, if a teenager had eligible compensation of $2,500 in 2021, the maximum IRA contribution he could make is $2,500, even though the annual IRA contribution limit for 2021 is $6,000.
Does Our Financial Organization Allow Minors to Open IRAs?
When a minor opens an IRA, she is entering into a contractual agreement with your financial organization. While federal law allows minors to own IRAs, state laws can restrict a minor’s ability to enter into a valid contract, including an IRA plan agreement. In many states, a contract requires a parent’s or legal guardian’s co-signature. In some states, a parent is automatically considered the guardian and authorized to handle the minor’s legal affairs, including making decisions about the IRA, until the age of majority is reached. The definition of “age of majority” can vary from state to state. Some financial organizations may be restricted by their own governing regulations from allowing a minor to select certain types of investments within his IRA, or for the minor to establish a relationship with the financial organization.
Your financial organization’s compliance team, including its legal counsel, should establish procedures to follow when a minor opens an IRA. The procedures may be the same as when minors open other types of accounts at your organization.
What Information Do We Need?
As part of your financial organization’s customer identification program, you must, at a minimum, obtain and verify the following information for both the minor and adult co-signer before opening an IRA.
Name
Date of birth
Address
Tax identification number (generally a Social Security number)
If a parent or guardian is co-signing the IRA documents, including proof of disclosure statement receipt, the adult’s signature should clearly appear on each of the IRA opening document forms. The adult’s relationship to the minor should also be noted.
Can a Parent, Grandparent, or Other Person Contribute to a Minor’s IRA?
In a manner of speaking, yes. Many parents and grandparents contribute to IRAs on behalf of a minor child. There’s no requirement that the funds being contributed to a minor’s IRA must be his “own money.” The minor just has to have eligible compensation sufficient to support the contribution.
Roth or Traditional IRA?
A minor—in all probability, having little income and not participating in an employer-sponsored retirement plan—would likely be eligible to make either Roth IRA contributions or tax-deductible Traditional IRA contributions. Because many minors have so little annual income that they are not subject to taxation or required to file an income tax return, the tax deduction commonly sought when making a Traditional IRA contribution may be of little value.
On the other hand, the Roth IRA may be a tax-smart choice, as Roth IRA contributions are distributed before any earnings and are always tax- and penalty-free. This can be an advantage if funds are needed before retirement, such as to pay higher education expenses. Once contributions are depleted, any earnings distributed for such a need would be taxable, but not subject to the 10 percent early distribution penalty tax. What’s more, if a Roth IRA has been open for five years and distributions qualify under first-time homebuyer rules, Roth IRA earnings that are distributed would be tax-free.
(As always, those who open and contribute to an IRA may wish to seek competent tax advice.)
