A child’s safety and security is the chief concern of nearly all parents. They want the best for their children and wish to see them do well in life. One of the primary concerns for any parent is their child’s financial security. As per a recent study, almost 68% of American parents fear that their children will be in a financially weaker position than they are in the future. This can be due to several reasons such as when you are young, you are more focused on getting through school, submitting assignments, participating in extracurricular activities, and other adolescent challenges. During this time, saving for retirement is not the priority of most teenagers. Moreover, being young, they are not particularly concerned about having to start saving since retirement is a long-term goal. Here is where the parents, grandparents, and other family members can step in. Parents can kick start a savings plan for their kids by investing in effective saving mediums in the present.
A Roth IRA (Individual Retirement Account) is one such medium that can safeguard your child’s financial future as it offers the maximum tax advantages between the accumulation phase and the withdrawal period during retirement. It can also help imbibe financial discipline in your child and make them a fiscally responsible person. Suppose you deposit $10,000 today in your child’s Roth IRA. The funds accumulate returns of 8% each year. Assuming you do not make any further contribution to the account, in a period of 40 years, your child will have amassed $217,000 in their Roth IRA. If you wish to find out how you can incorporate a Roth IRA to secure your child’s financial future and set them up for retirement, consult with a professional advisor who can advise you on the same.
Let us discuss some insights on how parents can contribute to a Roth IRA for their children and help safeguard their financial future.
What is a Roth IRA?
A Roth IRA is a tax-advantaged retirement plan where you contribute after-tax dollars and earn tax-free returns on your money. You can also avail of tax-exempt withdrawals, provided you fulfill certain conditions. To qualify for tax-free withdrawals from a Roth IRA, you must hold the account for at least five years and withdraw your funds at the age of 59.5 years or more. If you fulfill these conditions, your drawings are deemed qualified and tax-exempt.
Though a Roth IRA is not thought of as a prime saving vehicle for children, it is still being recognized as one of the most advantageous for children due to the benefits offered by it. A Roth IRA is especially beneficial for those who start earning at a younger age. It is an ideal savings vehicle for kids since they have decades to allow their money to grow backed by the power of compounding. Further, a Roth IRA offers considerable flexibility in terms of withdrawals and usage of funds.
What is a Roth IRA for children?
Anyone, irrespective of age, can contribute to a Roth IRA, provided they have an earned income and there is no age restriction to open a Roth IRA. As per the IRS (Internal Revenue Service), earned income refers to any income received from a job or self-employment such as salaries, wages, business earnings, disability retirement benefits, commissions, bonuses, etc. For example, if your child earns money from babysitting or walking dogs around the neighborhood, it will be considered as earned income. As a parent or guardian, you can open a custodial Roth IRA for your minor child at any authorized bank or financial institution.
The Roth IRA account will be handled by an adult till the time the child is legally eligible to control the account. This means that any and all decisions related to annual contributions, distributions, and investments will be made by the parent or guardian. The legal majority age varies from state to state. Typically, a child can legally take control of their custodial account after reaching 18 or 21 years of age. Even when the parent or the guardian has control over the custodial Roth IRA, the child remains the beneficiary of the account. The Roth IRA funds should be used for the benefit of the child only. Let’s say, your 16-year-old child earns $4,000 each year from walking dogs and mowing lawns in the neighborhood. Suppose you invest this sum in a Roth IRA generating a 10% annual return and the child continues to save $4,000 each year in the account, he can accumulate savings of $1 million before he reaches 55 years of age. In addition, if the child adheres to the Roth IRA withdrawal rules and waits to withdraw his savings till he reaches 59.5 years of age, he can take out all his savings 100% tax-free.
With that said, your child may end up needing more than $1 million in the future to achieve a financially secure retirement. But they would have gotten off to a great start since you began saving in their Roth IRA early. Also, your child can meet other financial requirements through his Roth IRA contributions as well like paying college tuition, buying their first home, etc. Your child can use the Roth IRA funds as required since no restrictions are placed on the usage of money from a Roth IRA. Further, the IRS does not mandate taking out Required Minimum Distributions (RMDs) in a Roth IRA. Not having to take out RMDs can help your child’s Roth IRA grow exponentially over a long period of time.
It should be noted that your child can contribute to a Roth IRA only if they have an earned income and cash gifts, investment returns, or allowance money (even if the child works for it) are not considered as earned income and are ineligible for a contribution towards a Roth IRA. With that said, if you own a business, your child can complete work-appropriate tasks in return for reasonable compensation.
What are the rules concerning contributions, penalties, and tax for a Roth IRA for children?
A custodial Roth IRA also has a maximum contribution limit similar to any other Roth IRA. For 2022, you can contribute a maximum of $6,000 to the Roth account. However, if your child’s earned income is lower than the maximum permissible limit, he can only contribute the earned income amount. For example, if your child earns $3,000 through babysitting, he can only contribute $3,000 to his Roth IRA and not $6,000 for 2022. If the child makes a contribution above the limit, he is liable to pay a 6% penalty every year until the error is corrected.
Additionally, you should keep a written record of your child’s earned income in case he is not filing a tax form for the same. Maintain a record of all receipts and information. This should include information related to the kind of work done, duration of work, employer (for whom the work is done), and payment received. This can be useful information in case the IRS inquires about your child’s earned income.
Can parents make a contribution to their child’s Roth IRA?
Yes, a parent can contribute to their child’s Roth IRA. It can be quite challenging to convince a child to save their earned money for future financial security. A child may wish to spend their money on a fancy new smartphone, the latest gaming console, a laptop, watching movies, college tuition, or buying their first car, etc.
Thus, if you are unable to convince your child to contribute their earned income in a Roth IRA or you wish your child to have fun using their own money, you can contribute to the Roth IRA on their behalf. As long as the child has earned income, you can contribute up to the amount earned by them. For example, if your child earned $3,000 working during the summer, you can allow your child to use that money for their personal needs and make an equal contribution of $3,000 in their Roth IRA from your earned income. You can either contribute the whole amount or a percentage of what your child earns, such as 80%, 65%, 50%, etc.
It is not important who contributes to the Roth IRA account as long as the contribution comes from an earned income. Also, the child should be able to justify earning the same sum as contributed to his Roth IRA account. You cannot contribute a sum exceeding the earned income of your child to the custodial Roth IRA. For instance, if your kid earned a sum of $2,500 by selling lemonade in the summer, you can only contribute an equal amount or a lesser contribution to their Roth IRA from your money. The sum contributed by you to your child’s Roth IRA cannot be used to derive any tax benefits in your favor. However, this does not affect your contribution to your own Roth IRA. You can contribute up to the maximum of your contribution limit, provided you have sufficient earned income to do so. Say, you had an earned income of $12,000 in 2022, and contribute $5,000 to your child’s Roth IRA, you can contribute $6,000 in your Roth IRA if you are under the age of 50; and $7,000 if you are over 50 years of age.
Additionally, you need to educate your child about the custodial Roth IRA, its functions, investment options, contribution limits, penalties, withdrawal criteria, etc. to help him build financial discipline. Doing so would impress upon him the value of saving money and being fiscally prudent and responsible. It would also allow him to make wiser decisions when he gains control of his Roth IRA when he comes of age.
What are the advantages of having a Roth IRA for your child?
Being a tax-advantaged savings account, a Roth IRA can offer several advantages to children. These are:
1. Helps to become financially literate:
By opening a Roth IRA for your child, you help them learn valuable financial lessons about the importance of earning, saving, and investing money to build a financially secure future for themselves. It also allows them to understand important financial aspects like the power of compounding, investing in different classes of assets, the relevance of investment risk, etc.
2. Facilitates wealth building:
A custodial Roth IRA helps your child to save for their higher education expenses or build a significantly large nest egg for retirement. The earlier your child starts contributing to a Roth IRA, the greater is the power of the account to accumulate wealth in the long term.
3. Offers flexibility in usage of funds:
A Roth IRA offers greater flexibility and does not impose any restrictions on the usage of funds. The Roth IRA money can be used to pay for your child’s college tuition, cover a financial emergency involving your child, purchase a home for your kid or save for retirement.
4. Boosts tax savings:
Since after-tax dollars are contributed to a Roth IRA, you or your child cannot claim a tax deduction in the present for any money contributed to the Roth account. This works out in your child’s favor as children usually have low annual earnings and little or no income tax is applicable on their earnings. However, when they grow up and start taking distributions, they may be subjected to a higher tax rate. Having a Roth IRA in the present helps them lower their future tax implications as they can make tax-free withdrawals provided they meet the 5-year holding rule and the 59.5 years age restriction.
To conclude
A Roth IRA can be a great present for your kid that will allow them to make tax-free earnings from a young age. Not only does this help your child build financial discipline and set a strong foundation for their future, but they would also be thankful to you when they grow up for having set up a Roth IRA for them. If you wish to gain further clarity on how to effectively fund a Roth IRA for your child, consulting with a financial advisor may be a wise idea.
To get in touch with a fiduciary advisor who may help you understand the benefits and drawbacks of opening a Roth IRA for your child, help build a retirement corpus and suggest an investment strategy, use the free advisor match service. Answer a few simple questions about yourself and the match tool will help connect you to 1-3 financial advisors based on your financial requirements.