Should You Open a Custodial Roth IRA for Your Kids?
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Last updated 04/09/2024 by
Andrew LathamSummary:
Roth IRAs are designed for investors with low incomes and long-term horizons, which makes them perfect for children. Find out what a custodial Roth IRA is, how to open one, and why your kid should have one.
Yes. If you have kids who earn income — more on what counts as income below — you should definitely open a custodial Roth IRA for them. Here’s why.
Top reasons your child should have a Roth IRA
- Roth IRAs are ideal for people who expect to have a higher tax rate when they retire than when they contribute toward their retirement account. This is because all the money you withdraw from a Roth IRA (contributions and earnings) is tax-free at retirement.
- Roth IRA contributions are not tax-deductible. This makes them ideal for people who don’t pay taxes anyway.
- The money you contribute to a Roth IRA grows tax-free. So, it is particularly attractive for people who have plenty of time before they retire to enjoy the rewards of compound interest. To illustrate, even if you only invest $5,000 and make no other contributions, you will have $329,400 after 60 years, assuming a 7% investment return and monthly compounding.
- You can access the money you contribute to a Roth IRA at any time and use it for whatever you want. This makes Roth IRAs the perfect hybrid retirement/education savings account.
- You can use a child’s Roth IRA to invest in a wide selection of assets, such as bonds and stocks. These provide much higher returns than traditional children savings accounts.
As you can see, children check all the boxes when it comes to Roth IRAs. However, most people don’t think of Roth IRAs as a savings account for kids, but they should. The truth is you would be hard-pressed to find a savings vehicle that is better suited for children.
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What is a custodial Roth IRA?
A custodial Roth IRA is a regular Roth IRA that you open for your child. When you open a custodial Roth IRA, you list your child as the beneficiary and yourself (or whoever is opening the account) as the custodian. These accounts allow your child to start enjoying the benefits of tax-free compounding early on.
Can I open a Roth IRA for my child?
There are two rules you have to follow when opening a Roth IRA. First, your child must have earned income. Second, you can only contribute as much as she earned. So if your child earns $100 a month, the maximum she can contribute is $1,200 a year ($100 x 12).
How to open a custodial Roth IRA?
Once you have a child with earned income, opening a custodial Roth IRA is as easy as contacting your bank, broker, or investment management company and opening an account. You will just need to provide personal information for you and your child (i.e., Social Security numbers, birthdates, etc.). The whole process should only take 10 to 15 minutes to set up.
The companies listed below are a great place to start if you are looking for an investment advisor.
How can young children earn an income?
The IRS does not have a minimum age for earning income. The easiest way for a child to earn money is to get paid for household chores. Think weeding the garden, washing dishes, babysitting, sweeping, and dusting. If you own a small business, they can help you with practically any age-appropriate task. Even small children can start earning income for basic chores. Older children can also start working for relatives, friends, and neighbors.
How to fund your child’s Roth IRA
It’s also worth noting that you don’t need to use the very same money your child earned to fund the Roth IRA. Anybody can contribute to the Roth IRA. Grandparents, uncles, and friends can all pitch in. The only limitation is how much income your child earned. So, let’s say your child receives a weekly “salary” of $20 for their housework. They can spend it on whatever they want income or this year’s IRA contribution limit, whichever is smaller.
Custodial Roth IRAs and taxes
It is important to keep good records whenever you are working with the IRS. Every time your child does a job, save a record. This can be automated, but make sure you have a good paper trail for the income your child earns. It’s a good idea to make sure you collect the following information.
- What work your child did and for how long.
- How much they were paid.
- When you paid them.
- How much of their pay was in cash.
The IRS requires you to keep employment tax records for at least 4 years after the due date of the return on which you report the taxes or the date the taxes were paid. However, it doesn’t hurt or cost money to keep those records, so it is a good idea to play it safe and keep them longer.
Do children have to file tax returns?
In general, it is only necessary (or beneficial) for minors to file a tax return if they have an income that is higher than the current standard deduction ($12,550 in 2021) or if their investments earn more than $1,100 a year (a.k.a kiddie tax).
What are the pros and cons of getting a custodial Roth IRA?
There is a lot to love about a Roth individual retirement account. However, there are also some disadvantages when compared to other savings options. Here is a list of the main pros and cons to consider when shopping for your child’s savings account.
Five reasons you should open a custodial Roth IRA for your children
There are several options available when it comes to vehicles for children’s savings. You could choose a traditional savings account in your local credit union, open a 529 Plan, A Coverdell Education Savings Account, a UGMA custodial account, or set up a trust. So, why should you choose a custodial Roth IRA to start saving the money your child has earned? Here are five reasons.
1. No early withdrawal penalties on contributions
Most retirement accounts will charge a 10% penalty if you withdraw money before you are 59½ years old. Roth IRAs allow you to withdraw the money you contributed to the account at any time without penalties. This is great for children since it gives them the option of spending some of their savings on educational expenses, travel, a car, starting a business, or practically anything else without worrying about fees and taxes.
Note, however, that the same can’t be said about the earnings of your contributions. If you withdraw earnings from the account, you will be hit with a 10% penalty, and you may have to pay income tax on the distribution also.
To illustrate, imagine your child has $10,000 in her account: $7,000 is from her contributions, and $3,000 is money she has earned through her savvy investments. She could withdraw up to $7,000 without paying a dime in penalty fees. However, withdrawing the full $10,000 would probably cost her a penalty fee of $300 (10% of $3,000) plus whatever taxes she owes.
The good news is that after 5 years, your child could withdraw up to $10,000 of her earnings without triggering a penalty.
2. Time is on their side
You typically expect young people to open individual retirement accounts (IRAs) when they get their regular paycheck. But the earlier, the better. Because children have many decades before them, they can take full advantage of the power of compounding interest within this type of tax-advantaged savings vehicle.
3. Custodial Roth IRAs are ideal for people in low tax brackets
Most kids don’t make enough money to benefit from the up-front tax deduction associated with traditional IRAs, so it makes sense to give Traditional IRAs, which are tax-deductible a pass. Roth IRAs are the best choice for minors because they will have a larger income (and therefore a higher tax bracket) when they retire.
A Roth retirement account is a good idea even if your child doesn’t use the money for retirement since their income is likely to be higher whenever they withdraw the money.
4. Roth IRAs can earn much more interest than traditional deposit accounts
The national average savings interest rate is 0.06%. Checking accounts earn, on average, 0.03%, and even 12-month CDs only get 0.14%. In contrast, inflation is around 2% per year. A traditional savings account will ensure your child doesn’t lose any money, but it also practically guarantees the value of their money will be lower when they withdraw it.
In contrast, a Roth IRA allows you to invest in much more lucrative assets. There are, of course, no guarantees in investing. However, investors with a well-diversified portfolio, such as a broad market index fund that tracks the S&P 500, have an excellent chance of seeing good returns over time. Historically, the S&P 500 has returned 7% per year after adjusting for inflation.
5. You can use the money in a Roth IRA for whatever you want
Saving for the retirement of a child may seem strange when they have so many large expenses to consider, such as paying for college, buying a car, or purchasing their first home. But that is the beauty of a custodial Roth IRA. You can use the money you contribute for whatever you want. So you are getting a flexible savings account that offers tax-free growth.
Next step
Even small contributions to a custodial Roth IRA can grow into substantial savings if they are regular and you allow compound interest to do its magic.
- Brainstorm as a family how your children can start earning income.
- Wait till your child has earned income.
- Open a custodial Roth IRA.
- Start funding your child’s Roth IRA.
Training your child to save for the future is a valuable lesson, regardless of the savings account you choose or how much they end up saving. Earning income early on can also help them develop a good work ethic and impress on them the value of money and how to manage it.
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Andrew is the Content Director for SuperMoney, a Certified Financial Planner®, and a Certified Personal Finance Counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.
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