Turn Your Kids Into Millionaires

As millions of Americans prepare their income tax returns, many of them consider opening an IRA or adding money to one they already have, attracted by tax benefits and the chance to build a better retirement.

However, IRAs aren't just for grown-ups. If you're a parent or grandparent of a working teen or working college student, an IRA contribution for your kid can have big rewards beyond those measured in dollars and cents.

The Ticket to an IRA: Earned Income

Some people are surprised to learn kids can have IRAs, too. "There's no minimum age for contributing to an IRA. The only requirement is that the IRA owner has an earned income," says JJ Montanaro, a CERTIFIED FINANCIAL PLANNER™ practitioner at USAA.

The child's income doesn't necessarily have to come from a formal job, either — baby-sitting and yard work count, too. Bona fide work around the house is also fair game. If your child earns money from an informal workplace, however, it's important to keep detailed records and report the income to the IRS. Keep in mind that allowance, child support and money from investing aren't considered earned income.

While your child must have earned income, the IRA money can come from you. "The contribution doesn't have to come directly from the child. The important thing is that the amount doesn't exceed your child's earned income," says Montanaro.

The contribution also needs to stay within the overall IRS contribution limit for someone under age 50 — for 2014, that's $5,500.

A Child's Biggest Financial Asset

Youngsters may have slim bank accounts and modest incomes, but they have one asset in great abundance: time. And when it comes to building a nest egg, that's a significant advantage.

"If you start young and save actively for a long time, then given historic rates of return you'll accumulate a very comfortable nest egg," says Anthony Webb, a senior research economist at the Center for Retirement Research at Boston College.

How comfortable? Let's say you help a child start an IRA at age 15 at a pace of $2,500 every year through age 22. At age 67, assuming an 8% rate of return, that relatively modest contribution of $20,000 would grow to over $900,000. That's thanks to the power of compounding. In other words, you earn interest on your original investment, but also interest on the interest accrued through age 67.

Now, let's step back and assume that instead of just leaving it at that, the child, turned young adult, picks up the good habit, takes over at age 23 and starts adding $5,500 a year. The beauty of compound interest means that he or she would have over $3 million socked away at age 67.

Traditional or Roth?

Which type of IRA is best for this strategy? According to USAA's Montanaro, a Roth IRA — which allows tax-free withdrawals in retirement — is probably the best bet. "Roth IRAs make the most sense if you'll be in a higher tax bracket when you withdraw the money than you were in when you contributed it," says Montanaro.

A Roth IRA has another advantage: Withdrawals are taken from contributions first, and they come out tax-free. Ideally the account will be left intact until retirement, but this feature allows some of the money to be pulled out for other purposes.

One of those purposes might be college. That brings up another benefit of a youth IRA: The value of an IRA isn't considered an available asset in calculations for federal financial aid for college.

Setting the Stage for Financial Success

The benefits of a youth IRA aren't measured only in dollars and cents. In a nation that struggles with financial literacy, exposing young Americans to saving and investing may help them build strong habits and financial savvy that extend well beyond retirement planning.

"It gives parents the opportunity to have conversations about saving and investing, which may be as valuable as the actual investment itself," Webb says.

To encourage strong savings habits, Montanaro suggests parents and grandparents consider borrowing an idea from employer retirement plans and offer to make "matching contributions" using whatever ratio they'd like as long as the total contributions don't exceed the child's earned income.

"With an informal matching contribution arrangement, you can prepare them to make informed decisions with their future employer plans and build a savings habit that will serve them well for a lifetime," says Montanaro.