Ric Edelman is right about kids' IRAs, but there's another option too

Unlike his incorrect advice on Roth 401(k)s and dollar-cost-averaging withdrawals, Ric Edelman's answer today on IRAs for kids was correct, but he missed the opportunity to point out another option.

On today's radio program, a caller asked about children needing earned income to contribute to IRAs. He wanted to be able to start his kids investing early to take advantage of many more years of compound growth. Edelman suggested that the caller pay his kids as employees for chores, issuing them an IRS 1099 form and creating earned income eligible for IRA contributions.

That's one option, but there's another that's almost as tax-advantaged for kids and less restrictive. You can open a taxable custodial account for kids (called UGMA or UTMA) at any brokerage like Charles Schwab or Fidelity. You can give the kids as much as you want up to the gift tax limit (currently $15,000 per parent or other giver per year). You can then invest in whatever stocks, ETFs, or funds you want.

For kids, a taxable account is essentially as tax-advantaged as an IRA. Kids get the minor unearned income exemption, currently $2,200 per year. With dividend yields below 2% and little capital gains from index funds, that makes the account essentially tax-free until it gets really big. And you can even realize gains tax-free in order to step-up the cost basis.

Assuming we're talking about a Roth IRA (there's little point in using a traditional IRA for a child in a zero or very low tax bracket), here's how a taxable account compares to a Roth. You get much bigger contribution limits and more flexibility for withdrawals. And the tax treatment is quite similar until the account grows large or the child grows up and is in higher tax brackets as an adult.

Roth accounts' permanent tax-free treatment (at least unless Congress changes the law) still has the edge over taxable accounts if the money is meant for retirement. But why not do both? Open a Roth, but also put some money in a taxable account that is essentially tax-free in the early years and can be used for college or a first home purchase or anything else in the early adult years.

Disclaimer: The W.C. Varones Blog is not a CPA or a tax adviser. Always consult your own tax professional.

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