04 Jan Start a retirement fund for grandkids

Q. I’m thinking of starting a retirement savings account for my grandkids. Can I start an IRA even though they’re not old enough to work? If I can’t, what should I do with the money?
— Grandpa

A. Starting a retirement account for grandchildren is a wonderful gift.

You first need to decide what kind of account you’d like to open for them.

You didn’t say how old your grandkids are. If they have earned income, they would be eligible to contribute to a traditional IRA, said Michael Cocco, a certified financial planner with AXA Advisors in Nutley.

Cocco said they’d receive an upfront tax deduction on contributions, but the entire account would be taxable upon withdrawal. If they take the funds out before age 59 1/2, they may face an additional 10 percent penalty for premature withdrawal.

Another option would be a Roth IRA, where there is no tax deduction upfront, but the money grows and can be accessed tax-free after age 59 ½, Cocco said. They’d also be able to access their principal tax-free and penalty-free at any time.

For either kind of IRA, they can save 100 percent of their earned income up to $5,500 for the 2015 tax year, and contributions can be made until the tax filing deadline.

Cocco said if they have earned income, he’d suggest contributing to the Roth IRA.

“The reason to choose Roth versus traditional is that they are probably in a very low income tax bracket, so the potential tax deduction they would get by using a traditional IRA would not provide them with substantial savings,” Cocco said. “Plus, they have the added flexibility of access to the principal, if needed.”

If you own a business, you have another opportunity.

You can hire your grandkids and give them up to $6,300 annually income tax-free, said Jerry Lynch, a certified financial planner with JFL Total wealth Management in Boonton.

He said they can use their standard deduction to shelter all the income and pay no tax, Lynch said.

That would give them the earned income they’d need to invest in an IRA.

Lynch said he’d choose the Roth option.

“They would be in the lowest tax bracket of their life and that money will be the most powerful money they have for retirement due to the power of compounding,” he said.

He offered this example.

Let’s say you have a 10-year-old grandchild who comes to help clean up your office on weekends. They earn $5,000 for the year and you put that into a Roth IRA, just for that one year. If the account earns 8 percent for 60 years — assuming they retire at age 70 — the account would be worth $6.27 million dollars.

“You have to realize that in 60 years that $6.27 million will be worth much less due to inflation, but it is still it is still one heck of a start for retirement,” Lynch said.

Also, this money would be protected from creditors, he said.

If they do not have earned income, then both the traditional IRA and Roth IRA would be off the table.

Cocco said one option would be to invest in a low-cost stock index mutual fund or exchange-traded fund (ETF), where you can add money for them each year to help accumulate savings that can be accessed by them at any time.

“One downside with this option compared to the Roth IRA is that the child — or his parents — would have to pay income tax on any dividends, interest or capital gains generated by the low-cost stock index or ETF fund since it does not grow tax-deferred or tax-free,” he said.

Also, you may be subject to a $14,000 per child maximum gift tax free contribution each tax year, which the IRS says is the maximum amount one person is allowed to gift another person for 2015, Cocco said.

“If you want to contribute more towards their account in any one year, federal gift tax filing Form 709 may be required to be filed,” he said.

Also, if this fund is in their name with you as custodian, you would be required to turn it over to them at their age of majority, which in New Jersey is age 21.

If you can’t do the IRA options, Lynch said you could put the money in a 529 Plan for college.

“That money would also grow tax deferred and can be used income tax-free for college,” he said.

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This story was first posted in January 2016.