We Need a Baby IRA

After last week’s article on whether there is bad timing with the market, I was reminded of an article I saw years ago. We’re going to cover today why I wish the government would allow IRAs for kids.

We all know the power of compound interest. There is the old rumor that Einstein even said it was the most powerful force in the universe (I really do not believe he said this). The earlier you can start saving the better off you will be down the road.  We also know the benefit of being able to defer taxes in our investments because it’s not what you make, it’s what you keep.   What if there were a way for us to save for kids in a tax-deferred manner even if they did not have income? Again, a baby IRA.

Here’s the basic concept – allow parents to open an IRA-type of investment for newborns and fund it until they hit the age of majority. To keep things simple, let’s say you can save $1,000 a year and parents get the tax deduction for the contribution.  

Now, before we get into the specifics, let’s deal with a couple of thoughts that may be going through your head.

First, aren’t there already savings vehicles for minors, like UTMAs and UGMAs (Uniform Transfers to Minors Acts and Uniform Gifts to Minors Acts)?  Yes, there are. However, it has a huge difference from the Baby IRA concept – taxes!  UTMAs and UGMAs are both funded with after-tax dollars. Yeah, the funding is coming from the parents anyways because most 1-year olds are not dealing with taxable income. The bigger issue is there are taxes on earnings within these accounts. The first $1,050 of earnings is tax-free. The next $1,050 of earnings is taxed at the kid’s rate, which we assume is lower than the parent’s rate. Anything above $2,100 of earnings is taxed at the parent’s rate. Then there’s the whole issue of turning the account over to the kid at age 19.

The next big question you may be thinking is – can’t my child open an IRA or Roth IRA as a minor? Yes, they can. Again, the issue is they must have taxable earnings to do this and most minors do not have taxable income until they hit the 15 or 16-year range. Think of all those early years (ages 0-15) they could have been saving and taking advantage of compound interest!

Alright, let’s now get to the meat of this whole concept. What happens if a Baby IRA did exist? You know, how much could that account grow to by the time they hit retirement? I’m not that bright so I am going to keep things simple here. We are going to assume $1,000 goes into the Baby IRA annually from birth through age 18. The rate of return is 8.8%. This is based on 50 years of historical returns for an 80/20 portfolio split between US stocks and corporate bonds respectively.  Yes, we are going to be aggressive with the investments as the child literally will not be touching this money for nearly a lifetime. No more contributions go in after the first 18 years so we let the funds just continue to grow in a tax-deferred account until they hit age 70. At this point their account is now worth in excess of $3 million.

You read that right. Before I forget, this assumes no fees with the investments. Unfortunately, I cannot calculate the impact of fees easily, but please focus on using low cost ETFs and indexes. Obviously no taxes because it is in a tax-deferred account.

I wonder what would happen to Social Security if something like this were available. I have to think the reliance on Social Security would decrease. However, it would be decades before we saw the benefits of Baby IRAs. But isn’t the expression the two best times to plant a tree are 30 years ago and today?  Regardless, I wish there was a Baby IRA for all of us.