Farrell: Consider an early start for funding a Roth IRA

Q: After reading a recent article about funding family members' IRAs, we are considering establishing a Roth IRA for our 3-year-old granddaughter and making annual contributions. She could access this for college if needed or retain it for her later life. What options are available for setting up a Roth IRA that do not require using a fee-based financial adviser?

Greg

A: You don't need a fee-based financial adviser to set up a Roth IRA. Banks, credit unions, online brokers, discount brokers, full-service brokers, mutual fund companies, and other financial institutions will set up a Roth.

For example, you could go with one of the mutual fund behemoths, such as Vanguard, Fidelity, T. Rowe Price or TIAA-CREF. You can decide on your own where to invest the money. So, there's no need to pay a planner.

You will have to shop around a bit more to find a financial firm willing to set up a custodial Roth IRA. But it won't be too hard. A custodial account allows a child to own securities. You control the account, but the child owns the assets.

The lure of setting up a Roth for your 3-year-old granddaughter is harnessing the power of compound interest over decades. The money that goes into a Roth is after-tax dollars. The gains are tax-free when cashed in during retirement.

Take this example drawn from "The Roth IRA for Children: Multigenerational Wealth Planning,'' by Mark Haug of the University of Kansas and accountant Adrienne Cichelli. A child contributes $500 a year for nine years into a Roth, starting at age 10 until age 18. No more contributions after that.

You can play with the numbers in different ways, but in the end the result is always the same: Starting early pays off big.

Here's the rub: (You knew that was coming, didn't you?) A Roth IRA — all IRAs, for that matter — must be funded with compensation she has earned. The earned income can come from a job or self-employment, but it has to be earned. It is far easier to help a teenager open a Roth funded with their earnings from packing groceries, working at a fast-food place, mowing lawns, baby sitting, caddying, and so on.

I have known very young children to have an IRA account, but it has usually been through an unusual opportunity, such as a modeling job or two as a baby or toddler.

You may want to wait, perhaps establishing a tax-sheltered college savings account for now and then encourage your granddaughter to set up a Roth with you when she starts making money, say, at a summer job.

I always recommend creating a paper trail with a Roth for a youngster, even though the odds of being questioned are minimal. It's simplest if the job comes with a W-2, an automatic tax trail. You can file a Form 1040 return for self-employment income.