While some start college savings plans for a new baby, not many think about starting a retirement account for a child. Although college savings are an excellent place to start, you may also want to consider opening a Roth IRA when a child gets a little older and starts earning money.
Roth IRAs can be a great savings vehicle for kids since it lets them grow their money tax-free and even withdraw funds early in some circumstances. It can even help them boost their Social Security income significantly.
Let’s take a look at what a Roth IRA for your kids has to offer, the requirements to open an account, and why it might make good sense to set one up for the child in your life.
Types of IRAs for kids
You may be familiar with the traditional and Roth individual retirement account (IRA) from your own retirement savings accounts. Still, you may not have ever thought about using one to give your kids a financial leg up.
Two types of IRA can be set up for kids: the traditional IRA and the Roth IRA.
Traditional IRAs are called pre-tax accounts and take money from your gross paycheck as contributions.
You pay income tax on those funds when you withdraw money during retirement at your applicable tax rate. Both contributions and earnings are subject to tax when you withdraw money from a traditional IRA.
A Roth IRA is considered an after-tax account, meaning you contribute money that you have already paid taxes on. Roth IRAs allow both contributions and earnings to be withdrawn tax-free after age 59 1/2 and if the beneficiary has owned the account for more than five years.
Parents, grandparents, or other family members can open what’s called a custodial account of either a traditional or Roth IRA on behalf of a minor. There are no minimum age requirements for setting up a custodial account, but the child must have earned income for contributions to be made to a traditional or Roth IRA.
The adult who opened the Roth IRA maintains control of the account until the child reaches the age of 18 or 21 (depending on the state). At that point, the assets must be transferred into a new account in their name.
In addition to the child’s contributions, adults can make gifts of contributions to the child’s account. Furthermore, any contributions made to a Roth IRA can be withdrawn without penalty for any reason. However, money that accrues in the account due to earnings are subject to withdrawal restrictions as we’ll see later.
How to set up a custodial account
Setting up a custodial account is about as easy as setting up your brokerage account and can be done for a child under the age of 18 by a parent, grandparent, or another adult in their life.
The custodian maintains control of the child’s Roth IRA and makes decisions about contributions, investments, and distributions until the child reaches the required age — generally 18 or 21 — depending on the state.
The child is the beneficial account owner, and all funds in the account must be for the benefit of the named child. In other words, you can’t pull out funds to help out another child or family member.
Money in the account from contributions can be withdrawn for any reason without penalty. Money in the account resulting from earnings can only be withdrawn without penalty if it benefits the child for whom the account was made, and only in certain circumstances which we’ll cover later.
Once the child reaches the required age, the funds can be transferred to a new account in the child’s name and can become the basis of their first retirement account.
Advantages of Roth IRAs for kids
It can be challenging for kids to wrap their heads around saving for retirement when the latest video game or gadget is right in front of them.
However, if they’re earning money outside the home, it can be a great time to introduce them to the benefits of saving for retirement along with ways to avoid throwing money away in their later years.
Here are some of the benefits of opening a retirement account for a child.
Since taxes have already been paid on the contributions, when the child is ready to withdraw funds decades later in retirement, they will be able to do so tax-free unless the rules change dramatically.
Money contributed to a Roth IRA (though not earnings), can be withdrawn without penalty or taxes at any time. That means that they can take out their contributions to help with college expenses, purchasing a first car or home, or helping with a financial emergency without penalty or taxes.
Although it's usually best to leave retirement savings to grow for as long as possible, the longer you’ve been making contributions to the account, the more there will be to draw from without penalty if it becomes necessary.
More time in the market equals more growth
While most people wait to start worrying about retirement until they get their first job with a 401(k), a savvy family member can give a child a head start on funding a comfortable and lasting retirement.
Opening a custodial Roth IRA is an excellent opportunity to teach a child about the value of compound interest. Compound interest can make a small investment grow exponentially, especially over thirty or forty years.
Take the opportunity to show your child or grandchild how compound interest works by using an online calculator. Start with their initial deposit and how it can grow over the decades, even if they don’t make any additional contributions. Then show them what their balance might look like if they continue to contribute over their lifetime.
Funds don’t have to be used only for retirement
Roth IRAs charge a 10% penalty on any withdrawal before age 59 1/2 except in certain circumstances, such as if the child becomes permanently disabled or has significant medical expenses.
Additionally, account holders can make a one-time federal tax and penalty-free withdrawal of up to $10,000 in earnings before reaching age 59 1/2 as long as the money is used for a first-time home purchase.
Roth IRA earnings may also be withdrawn penalty-free and possibly tax-free for qualified education expenses like college tuition or room and board. However, there are limits on the types of expenses that qualify.
Rules of Roth IRAs for kids
Before you rush out to set up a custodial account for every child in your life, remember that there are a few requirements that need to be met before you can start a custodial Roth IRA.
The child must have earned income
To contribute to a Roth IRA, the contributions have to come from earned income, which the IRS defines as salaries, wages, tips, professional fees, or other amounts received for work actually performed from either a W2 job or from self-employment jobs like babysitting or mowing lawns.
Adults can also contribute to a child’s Roth IRA provided that the combined contribution does not exceed the child’s earned income for the year.
If your child is working for an employer, their income can be easily tracked by looking at their W2 or tax return. For self-employed teens, earned income is the net earnings from the business, less any self-employment taxes and allowable deductions.
Teens who make money with a side hustle may want to keep a written log of their earnings, so there is a record if the IRS asks for proof.
While parents are not allowed to add additional funds to the Roth IRA, they can make the IRA contribution up to the amount earned by the child and let the child spend or save their money for other things.
For example, if your child earns $2,000 mowing lawns, you can make up to a $2,000 Roth IRA contribution from your own money, so long as it doesn't exceed what the child actually earned. You can’t go above what your child has made themselves, but there are no rules about which bank account contributes.
In 2022, the maximum your child can contribute to either a traditional or Roth IRA is $6,000, or their taxable earnings for the year, whichever is less. These are the same contribution limits for adult Roth IRA’s as well.
That means that even if your child earns $10,000 in earned income for the year, the most they can contribute (or you can contribute on their behalf) to the IRA is $6,000. If your child has no earnings, they and/or the custodian cannot contribute anything to the account.
How to open a kid’s Roth IRA
Opening a custodial Roth IRA for a child is relatively simple and should only take about fifteen minutes. Once you meet the requirements — usually that the child is under 18 years old and has earned income to make contributions — you should be ready to open an account.
- Start by finding a brokerage firm that offers custodial accounts. Many of the bigger firms, like Fidelity and Charles Schwab, offer these types of accounts, as well as investing apps like M1 Finance. Check out our M1 Finance review for more info.
- Gather the personal information for you and the child you want to open an account for. Any information you would need to open a brokerage account for yourself will also likely be required to open a custodial account.
- Complete the enrollment process and help the child make their first contribution.
Opening a Roth IRA for a child can be one of the simplest and smartest money moves to ensure they receive a solid financial footing through life. If your child has an after-school or summer job, consider opening a custodial Roth IRA to help them prepare for the future beyond college.
By ensuring that you give your child a solid financial footing, you’re giving them a headstart on their financial journey and helping them secure a better future.
More from FinanceBuzz:
Smart Asset Benefits
- Get matched with fiduciary financial advisors
- Advisors are vetted and certified fiduciaries
- Take the mystery out of retirement planning
- Their matching tool is free