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How to Open a Custodial Roth IRA For Your Children

A Custodial Roth IRA is an ideal saving instrument for children. As they are still very young at the time of opening the account, children can harness the power of compounding to grow their contributions. One of the best parts about Custodial Roth IRAs is that they are flexible, in the sense that you can withdraw contributions at any time. Moreover, they are penalty and tax-free. If you wish to understand a custodial Roth IRA better, how you can contribute to one, its limits and stipulations, get in touch with a professional financial advisor who can clarify the same.

Let’s learn more about Custodial Roth IRAs, its rules, different types available for investment and more.

What is a Custodial Roth IRA?

Individual Retirement Accounts or IRAs are a great retirement investment instrument. It can also help your child cover their educational expenses, purchase of their first car, or a first house. Given the amount of time that children have ahead of them until retirement, they can grow their wealth exponentially through the power of compounding. Compared to other retirement accounts, Custodial Roth IRAs are more flexible as you can withdraw the amount at any time.

Some important points to note here are:

  • Children of any age can contribute to a Custodial Roth IRA account, provided they have earned income. Parents or guardians can also contribute to the account if their contributions don’t exceed the earned income of the children.
  • Since it is a custodial account, a parent or an adult needs to set it up.
  • Although Charles Schwab and Fidelity offer Custodial Roth IRAs, not all banks or brokerage firms offer them.
  • You can choose between traditional and Roth IRAs. Usually, the Roth is preferred, as it favors those who fall under the higher tax bracket later in life.

What are the different types of Custodial IRAs?

There are two types of custodial IRAs for children – Traditional and Roth. The primary difference between the two lies in the amount of taxes you pay on the money that you contribute.

In the case of a traditional IRA account, you pay taxes at the time of withdrawal during retirement. This is charged at the then-applicable tax rate. In a traditional IRA, all your contributions are considered pre-tax.

In the case of a Roth IRA, you pay taxes when you put money into the account. As such, your contributions are considered after-tax money.

Both in traditional and Roth IRA, your money grows tax-free. However, in the case of Roth IRA, no tax is charged when the child withdraws money at a later point in time. Furthermore, you don’t have to pay required minimum distributions (RMDs) in Roth IRAs compared to traditional IRAs.

Further,if you claim your child as a dependent, the child needs to file an income tax return if their gross income is more than the amount set up by the IRA. Should your child earn less than this set amount, they will fall in the 0% income tax bracket and may not benefit from the up-front tax deduction of traditional IRAs.

What are some of the important Custodial Roth IRA rules for children?

  1. No age limit for opening a custodial Roth IRA

  2. There is no set age limit stipulated by the IRS for contribution to a Roth IRA. Any child, regardless of age, can contribute to an IRA provided they have earned income. Others can also contribute to the child’s IRA, as long as they take care to not exceed the amount of the child's earned income.

  3. Contributions must come from earned income

  4. As mentioned earlier, the hurdle to opening a custodial Roth IRA is income and not age. The child must have earned income to be able to contribute to a Roth IRA account. IRS defines ‘earned income’ as taxable income and wages, i.e., money earned from a W-2 job or through self-employment such as paper route, babysitting, etc.

    As a parent, you can also contribute and withdraw money from your child’s custodial Roth IRA, but the child must add their share of earned income to the total contribution amount.

  5. Contribution limits

  6. Among other custodial Roth IRA rules, there is a contribution limit mandated by the IRS that should not be exceeded. The contribution limit in 2021 was $6,000 and $7,000 in 2022 for age 50 or older, or the total of earned income for the year, whichever is less. For instance, if your child earns $2,000 from volunteering at a summer camp, they can put up to $2,000 into a Roth account.

    Some parents also choose to match their child’s earnings to contribute to the Roth IRA themselves. For instance, if your child earns $3,000 by babysitting, you can give them the freedom to spend that earned money as they wish, and you contribute $3,000 to the IRA yourself in their stead.

    Some parents also choose to contribute a percentage of their child’s earnings, such as 50%. For example, of the $3,000 earned by your child, you invest $1,500. The contributions to the IRA can also be a gift from you or someone else. No matter who contributes, the thumb rule is —it should not exceed your child’s earned income for the year.

How to open a Custodial Roth IRA

The main eligibility factor in opening a Roth IRA for your child is their income. Secondly, as mandated by law, investment companies typically need an adult or a parent to open and manage the account on behalf of a minor (under 18 in most states and under 19 and 21 in other states). As a custodian, you make the investment decisions and control the IRA assets until your child reaches the majority age.

Opening an IRA is fairly simple. The account is opened in your child’s name, and you will need to provide 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 benefits of Custodial Roth IRA?

There are several advantages to opening a custodial Roth IRA. These are:

  1. Early withdrawals

  2. One of the major advantages of a custodial Roth IRA is its flexibility—the freedom to make a withdrawal whenever you want. As against standard retirement accounts that have stricter distribution rules and charge a 10% penalty if the money is withdrawn before age 59½, Roth IRAs are more balanced. Distributions of investment earnings on Roth IRAs may be taxed as income, with a 10% penalty on early distribution tax or both.

    As such, a custodial Roth IRA is a good option for children who need convenient access to cash and also for parents who may want to save for their child’s college tuition.

  3. Tax-free withdrawals in retirement

  4. If you invest in Roth IRAs, you can make tax-free qualified distributions in retirement since you pay tax on the amount you contribute to the Roth IRA account. So, if you invest longer and your current tax rate is low, your earnings can grow at an impressive rate, provided they follow the distribution rules. Furthermore, most of the childrens’ earnings are so low that they pay little to no income taxes and save taxes on contributions too.

    Since the majority of children don’t earn enough money to take advantage of the up-front tax deduction of traditional IRAs, Custodial Roth IRAs are usually the preferred choice for minors with limited income.

  5. Maximize the power of compounding

  6. As with most retirement accounts, through Roth IRAs you can tap the power of compounding. For children who have started investing at a young age, they can earn more tax-free investment growth. All you need to do is sit back and let time work its magic. For instance, even a one-time contribution of $6,000 in a Roth IRA would grow to about $200,000 in 60 years at a 6% investment return and monthly compounding.

  7. Increased flexibility to cover various expenses

  8. A Custodial Roth IRA has several tangible benefits other than just being a retirement account. The idea behind opening a Roth IRA is to keep contributing to the account until you have collected a substantial amount of cash. Moreover, you can make tax-and penalty-free withdrawals after investing in the account for at least five years. Traditional IRAs also allow penalty-free withdrawals, but in special circumstances.

As such, Roth IRAs can be used to cover the following expenses:

  • Education and tuition fees: The account holder can withdraw money for college, including tuition, books, equipment, board expenses, other supplies, and fees. Although the children will have to pay tax on the earnings, there is no 10% early withdrawal penalty if the money is used for educational needs.

  • For purchasing a home: Before reaching the age of 59½, the account holder can encash the funds to purchase a house. The withdrawal amount is capped at $10,000 limited to first-time homebuyers. Remember, early cash withdrawals to buy a house are tax and penalty-free. The account holder needs to use the money as a down payment or for closing costs.

  • For emergencies: The account holder may withdraw money in case of an emergency. However, the withdrawal money is subject to taxes on the earnings. Moreover, there is a 10% penalty on an early withdrawal.
  • .
  • Opportunity to inculcate financial discipline: With a custodial Roth IRA, your child not only get a head start on saving for retirement, but it is also a good way to imbibe valuable financial lessons. At an early age, you present the children with the opportunity to learn about money, earning, saving, spending, and compounding. This increases their chances of creating financial stability for themselves in the future.

How to fund your child’s IRA

Children of any age can contribute to an IRA as long as they have earned income either from self-employment or from their own business.For 2021 and 2022, the maximum contribution a child can make to an IRA for both traditional and Roth IRA is less than $6,000 or their taxable earnings for the year. For example, if your child earns $3,000 this year, the child can contribute up to $3,000 to the IRA account. However, if your child earns $10,000, then they can contribute only $6,000 as the maximum contribution. In the case of zero earnings, the child cannot contribute at all.

As long as your child has earned income during the year, it can be put into the account as a contribution. Allowance money is not considered as earned income and cannot be used as a contribution. Although allowance or gift money does not qualify for the contribution, you may pay your children for work done around the house as long as it is legitimate work and you are paying as per the market rate.

To define ‘earned income,’ your child receives a W-2 or Form 1099. Since this does not happen with common juvenile jobs like dog-walking, babysitting, yard work, etc., you need to keep receipts to maintain a record of the earned income. The record should include:

  • Type of work
  • Duration of work
  • Details of the person for whom the work was done
  • The amount earned by the child

To conclude

Custodial Roth IRAs offer children a tremendous head start into investing—the major advantage being—time. Since the aim is to make an investment for the long-term, your contributions earn interest over time lending you financial security for the future. Investing in a Roth can also imbibe in children the importance of financial discipline early on in life and can inculcate this habit and carry it forward to their adulthood to maintain healthy finances and be on top of their taxes.

If you need guidance on growing and managing your finances to help fund your children’s future, use the free advisor match tool and 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.