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Top 3 Reasons Your Teen Needs a Custodial IRA

One of the most challenging aspects of raising teenagers is helping them develop good money management skills. Teaching them how to budget and save can help them build a solid financial foundation. Setting up a custodial IRA can help them start preparing for retirement. Basically, it’s a traditional or Roth IRA that you’ll maintain control of until your child becomes an adult. If your teen doesn’t have one, here are three reasons to consider opening a custodial IRA.

Find out now: How much do I need to save for retirement?

1. Compound Interest

Compound interest is a beautiful thing. When you allow interest to compound, your money grows more quickly because you’re earning interest on top of the interest you’ve already earned. Over a period of 20, 30 or even 40 years, it can significantly increase the value of your teen’s custodial IRA.

For example, if your teen holds the same job over a period of five years, from high school until their college graduation, they can potentially have thousands of dollars saved up by the time they collect their diploma.

2. Penalty-Free Withdrawals

Top 3 Reasons Your Teen Needs a Custodial IRA

A custodial IRA is designed to help your teen build their nest egg. The IRS imposes a 10% early withdrawal penalty when you pull this money out before age 59 1/2, unless you qualify for an exception.

Exceptions can be granted for certain reasons. For example, you might be able to withdraw up to $10,000 for a first home purchase. There’s no tax penalty but you or your child would have to pay income tax for taking money out of a traditional IRA (depending on whether you claim your child on your taxes or they file their own return). If your child has a Roth IRA, you might only owe income taxes on his or her earnings, since any contributions to the account would have been made using after-tax dollars.

Students can also use the withdrawals from their retirement accounts to cover tuition, fees and other eligible education expenses without paying a penalty (although they might have to pay income taxes). If your teen’s been saving steadily, that money can come in handy if he or she wants to avoid taking on student loan debt.

Check out our student loan calculator.

3. Tax-Advantaged Investing

Both traditional and Roth IRAs have certain tax advantages but having a Roth IRA can be particularly beneficial to young investors. With a Roth IRA, you don’t get any kind of tax deduction for what you contribute but once you turn 59 1/2, you can withdraw the money completely tax-free. A traditional IRA on the other hand, is fully taxable once you begin taking distributions.

There’s another good reason to consider opening a custodial IRA for your child in the form of a Roth IRA. If they expect to be in a higher tax bracket in retirement, having a Roth IRA would mean that they’d owe less in taxes.

Related Article: 3 Ways Parents Can Invest for Their Kids

Final Word

Top 3 Reasons Your Teen Needs a Custodial IRA

A custodial IRA can dramatically increase the size of your child’s nest egg over time. Setting one up is relatively easy and it’s a good idea to do it sooner rather than later. If you’re having trouble convincing your teenage son or daughter to part with a few bucks out of their paycheck, consider offering a matching contribution to encourage them to focus on saving.

Photo credit: ©iStock.com/Christopher Futcher, ©iStock.com/Christopher Futcher, ©iStock.com/Susan Chiang

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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