What is a Custodial Roth IRA and How Can I Open One For My Children?

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A Custodial Roth IRA is an Individual Retirement Account that a custodian (usually a parent or guardian) maintains and runs for a minor having an earned income. It is an ideal saving instrument for children where they can maximize the power of compounding to grow their contributions. The assets held in a custodial Roth IRA are managed by the custodian till the time the child reaches the age of majority i.e. 18 or 21 years of age depending on the state they reside in.

Custodial Roth IRAs offer flexibility to their investors as they can make penalty and tax-free withdrawals at any time. Your kid can make use of the funds to fund their higher education expenses, purchase his first home or put away the money for retirement. To gain a better understanding of custodial Roth IRAs, their limits and stipulations, taxability, and more consult with a professional financial advisor who can guide you on the same.

Let us first learn about the salient features of a custodial Roth IRA, its types, rules, benefits, and more in detail.

What is a Custodial Roth IRA?

As explained above, a custodial Roth IRA is a retirement savings account for kids who can use the account for several purposes such as covering their college tuition, purchase of their first car, or a first house. Since a child has a considerable amount of time to save for retirement, they can build a sizable retirement corpus and put the power of compounding to good use. An important benefit of a custodial Roth IRA is the ability to make a withdrawal at any given point in time.

Some of the essential features of a custodial Roth IRA are as follows:

  • Children of any age can contribute to a custodial Roth IRA account as long as they have earned income i.e. any income received from a job or self-employment such as salaries, wages, business earnings, disability retirement benefits, commissions, bonuses, assignment work, babysitting, etc. Parents or guardians can also contribute to the custodial Roth IRA account provided their contributions don’t exceed the earned income of the children.

  • A custodial Roth IRA account can only be set up by a parent or a guardian who is of majority age.

  • You can choose to open either a traditional IRA or a Roth IRA account based on your financial needs and objectives. Usually, the Roth account is preferred due to being able to make tax-free withdrawals in retirement and it favors people who fall under a higher tax bracket later on in retirement.

What are the different kinds of Custodial IRAs?

There are two kinds of custodial IRAs that you can choose from - Traditional IRA and Roth IRA. In a traditional IRA, you contribute pre-tax dollars and have to pay taxes at the time of withdrawal during retirement. Whereas in a Roth IRA, you contribute after-tax dollars and can make tax-free withdrawals in retirement subject to certain conditions.

In both traditional and Roth IRA, your money grows tax-free with the key difference being you must take out required minimum distributions (RMDs) in a traditional IRA whereas there is no such restriction in a Roth IRA. Moreover, if you claim your child as a dependent, an income tax return needs to be filed by the child provided their gross income is more than the amount set up by the IRA. If the child earns less than this set amount, it would place them in the 0% income tax bracket. This would not be beneficial for your child since he/she would be unable to take advantage of the up-front tax deduction of traditional IRAs.

What are the essential rules for setting up a custodial Roth IRA for children?

There are three essential rules for establishing a custodial Roth IRA for children. These are:

1. No prescribed age limit for setting up a custodial Roth IRA

The IRS has not stipulated any age limit for contributing to a Roth IRA. Any minor can contribute to an IRA, irrespective of their age, provided they have earned income. Any other individual can also contribute to the minor’s IRA as long as they are careful and do not contribute an amount more than the child's earned income.

2. Any contribution made must be from earned income

The sticking point to starting a custodial Roth IRA account is income and not age. If the child does not have an earned income, he would not be able to contribute to his account. Earned income here refers to any income received from a job or self-employment. Wages, salaries, commissions along with money earned from a paper route, babysitting, etc. can be deemed as earned income. Further, a parent or guardian can also contribute and withdraw money from their child’s custodial Roth IRA. However, the contributions must include the share of earned income of the child.

3. Contribution limits

The IRS updates the contribution limits for retirement accounts each year that must be adhered to by the investors. Failure to do so would attract penalties from the IRS till the time the error is rectified. For 2022, the contribution limit for a custodial Roth IRA is set at $6,000, or the total of earned income for the year, whichever is less. For example, if your child earns $4,000 from babysitting, they can contribute up to $4,000 into their Roth account.

In addition, some parents choose to match their child’s earnings and contribute to their child’s custodial Roth IRA in their stead. For example, if your kid earns $2,000 from his paper route, you can allow them to spend that money as they wish, and put up $2,000 in their Roth account yourself. Further, parents can also contribute a percentage of their child’s earnings, should they wish to, say, 50%. For instance, of the $5,000 earned by your child, you can invest $2,500. You or any other individual can also gift a contribution to your child’s IRA. The important thing here is that whosoever contributes, it should not exceed your child’s earned income for the respective year.

How can you open a Custodial Roth IRA?

You can start a custodial Roth IRA for your child provided your child has earned income and you open and manage the account on their behalf. If your child is a minor (under 18 in most states and under 19 and 21 in other states), being the custodian, you are responsible for making the investment decisions and controlling the IRA assets until your child reaches the majority age.

The process for opening an IRA is fairly straightforward wherein a custodial Roth IRA account is opened in your child’s name. You will also need to furnish details with respect to your and your child’s Social Security Number, birthdates, and other personal information.

[See: How to Find a Financial Advisor You Can Trust]

What are the advantages of a Custodial Roth IRA?

A custodial Roth IRA offers several benefits to its investors. These are:

1. Take out early withdrawals

A custodial Roth IRA allows its owners to make a withdrawal whenever they want. Compared to other IRAs that enforce strict distribution rules and charge a 10% penalty if the money is withdrawn before reaching 59.5 years of age, a custodial Roth IRA is more balanced. Any earnings made on investment are subject to taxation and may attract a 10% penalty on early distribution. Since you can make a withdrawal at any time, it is a good option for kids and parents who may want to save for their child’s college tuition.

2. Make tax-free withdrawals in retirement

Since you contribute after-tax dollars in a custodial Roth IRA, you can make tax-free qualified distributions in retirement. It is advantageous if your current tax rate is low as it would allow you to grow your earnings at a higher rate. Moreover, since most kids’ earnings are so low that they have to pay either little to no income taxes. This enables them to save taxes on contributions too. A custodial Roth IRA is a wise choice for children since most of them do not earn enough money to take advantage of the up-front tax deduction of traditional IRAs, making it an ideal investment option for them.

3. Harness the power of compounding

As with most forms of investment, if you want to harness the power of compounding, you need to invest for the long term. A custodial Roth IRA is an ideal investment vehicle for children as they can start investing from a young age and let time work its magic. For example, if you contribute a sum of $6,000 just once in a Roth IRA, in 60 years’ time, it would grow to about $200,000 at a 6% investment return and monthly compounding.

4. Cover multiple expenses due to high flexibility

A custodial Roth IRA offers multiple advantages to its investors such as the ability to make tax-and penalty-free withdrawals after investing in the account for at least five years. The aim is to make regular contributions to the account till the time you have accumulated enough savings to last your retirement years.

It can be used for covering several expenses such as:

  • Higher education or college tuition: You can use your custodial Roth IRA funds to cover expenses for college like tuition, books, equipment, board expenses, other supplies, and fees. The IRS mandates that the child will have to pay tax on the earnings, however, they would be exempt from having to pay the 10% early withdrawal penalty if the withdrawn funds are used for educational purposes.

  • Buying a home: You can use your custodial Roth IRA for buying a house before reaching 59.5 years of age. If you are a first-time homebuyer, you can withdraw a sum of $10,000 one-time which is tax and penalty-free. This amount must be used as a down payment or for closing costs.

  • Emergencies: In case of a medical or financial emergency, you can withdraw funds from your custodial Roth IRA, however, the withdrawn sum is subject to taxes on the earnings. In addition, you will incur a 10% penalty on an early withdrawal.

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  • Teach financial discipline: You can use a custodial Roth IRA to teach and inculcate financial discipline in your children along with giving them a head start on saving for retirement. It is a good opportunity for them to learn valuable financial lessons about money, earning, saving, spending, and compounding at a young age.

How to finance your child’s IRA

As stated earlier, a child can make a contribution to an IRA at any age provided he/she has earned income from either self-employment or their own business. For the year 2022, the maximum contribution a child can make to an IRA for either traditional or Roth IRA is $6,000 or their taxable earnings for the year, whichever is lesser. For instance, if your child earns $5,000 this year, the child can contribute up to $5,000 to their IRA account. However, if your child earns $8,000, then they can contribute only $6,000 as the maximum contribution. If your child failed to earn anything, then they cannot contribute any amount to their IRA.

The child can contribute to their IRA as long as they have earned income for the year. However, keep in mind that allowance money is not considered as earned income and therefore cannot be used to contribute to the IRA. Although you can pay your children for completing house chores as long as it is legitimate work and you are paying them as per the going market rate.

Your child receives a W-2 or Form 1099 as proof of earned income. This is not possible for common juvenile jobs like dog-walking, babysitting, yard work, etc., therefore, you would need to maintain receipts to serve as a record of the earned income. The record should include the kind of work done, its duration, details of the individual for whom the work was performed, and the amount earned by the child.

To conclude

By investing in a custodial Roth IRA, your child can truly harness the power of compounding. Not only do they get a big jump-start into investing, but they can also invest their money for a long-term horizon, allowing their contributions to earn interest over time, lending them financial security for the future. Investing from a young age also inculcates the importance of financial discipline in children. This habit can serve them in good stead in adulthood enabling them to maintain healthy finances, manage their expenses and taxes, and stick to a budget.

If you need guidance on how you can best make use of custodial Roth IRAs to grow and manage your child’s finances to help secure their financial future, use the free advisor match tool. Through this tool, you get matched with experienced and certified financial advisors who may be able to guide you effectively as per your unique financial requirements. Answer a few simple questions about yourself, and the free match tool will connect you to 1-3 advisors suited to meet your financial needs and goals.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.