How a Custodial Roth IRA Can Help Boost Retirement Savings for Your Kid
Custodial Roth IRAs are tax-advantaged retirement plans to secure your child's financial future. Learn about the limitations, tax-advantages, and contributions.
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- Parents and grandparents can open a Roth IRA for kids regardless of age, provided the child has earned income.
- Anyone can contribute to the child's Roth IRA, as long as they don't exceed the amount of the child's earned income.
- A custodian controls the Roth IRA until the child reaches majority age, at which point they can withdraw funds from it.
It's never too early to start savings on behalf of your child's future. Kids have decades ahead of them to save for retirement, which puts them in the prime (and enviable) position to take full advantage of a long-term investment strategy and the power of compounding.
One of the best custodial accounts for kids is actually a retirement saving account. Custodial Roth IRAs are among the strongest tax-advantaged retirement savings vehicles to grow long-term wealth.
Here's why you should consider opening a custodial Roth IRA and the tax advantages your kid can earn down the line.
What is a custodial Roth IRA?
A custodial Roth IRA for a child is a retirement savings vehicle for minors funded by after-tax dollars from their own earned income. The tax-advantages, investing opportunities, rules, and limitations are all the same as a regular Roth IRA.
Saving and investing are the keys to long-term wealth. Unfortunately, "most Americans lack the discipline to save an adequate amount as a percentage of their income," says Sam Davis CFP with TBH Global Asset Management. "So, inspiring savings early in a child's life can really help."
Because Roth IRAs allow for both tax-free growth and tax-free withdrawals, they offer a tremendous opportunity for young people.
But keep in mind that an IRA isn't an investment in itself. Rather, IRAs are the accounts that hold your chosen investments (such as stocks, bonds, ETFs, and mutual funds). Again, this is your job as a custodian until the child is old enough to take over.
Custodial or guardian accounts permit adult control over the assets in the IRA until the child reaches the age of majority (18 or 21, depending on the state). After that, the account and all investment decisions are turned over to them.
Custodial Roth IRA rules
Here's a breakdown of the rules for custodial Roth IRAs:
- The child must make an "earned income" to contribute to a custodial Roth IRA. Eligible income can come from entrepreneurial activities like babysitting, mowing lawns, dog-walking, wages from a job, tips, or prize money, as per the IRS. Allowances do not count as earned income.
- The child needs to have earned income equal to the contribution amount. That means your child must have garnered at least $7,000 to make the full contribution.
- Regular IRA contribution limits apply: For 2024, you can contribute up to $7,000 a year if you're younger than age 50. Investors 50 or older can contribute up to $8,000. In 2023, the contribution limit for IRAs was $6,500 ($7,500 if you're 50 or older).
- Custodial Roth IRAs are funded with after-tax dollars. The beneficiary won't receive a tax deduction for contributing funds but will have tax-free growth on withdrawals during retirement.
- The money in a custodial IRA cannot be accessed until the child is at least age 59 1/2 or is eligible for a penalty-free early withdrawal.
Anyone can contribute to a child's Roth IRA
It can be difficult to convince a child to deposit their earnings into their Roth IRA. The good news is that it doesn't necessarily have to be your child's money that actually goes into the account. If your child meets the earned income requirement, you or anyone else can contribute on their behalf.
"One idea that we've seen families implement that seems to be a good motivator is to implement matching funds," says Davis. "Only invest for a child what they are willing to invest themselves." So, for example, if your kid is willing to sock away $3,000, you can kick in another $3,000 to max out the contribution.
Usually, you can't contribute to a Roth IRA if you make $161,000 annually in 2024 ($240,000 if you're married). But in this case, your income threshold doesn't matter. The only income the IRS cares about is the child's.
Benefits of a custodial IRA
Setting up a Roth IRA for your kids now can help them secure a comfortable retirement later. By starting an IRA at a young age, your child can take full advantage of the power of compounding. After all, a single $7,000 investment made today could be worth more than $300,000 in 50 years, assuming an 8% annual return.
Moreover, a Roth IRA of one's own can foster a lifetime of healthy money habits.
"It's a great way to help educate their kids on the savings process while investing tax-efficiently," says Davis.
Drawbacks of a custodial IRA
One potential drawback of a Roth IRA for kids is that your child may eventually make too much money to continue funding the account. Of course, that's not necessarily a bad position to be in, as the account will continue to grow tax-free even without additional contributions.
Another consideration: The account will be in the child's control once they come of age. They can do whatever they want with it, and you won't be able to stop them. If they were to withdraw earnings from the IRA before they reach the age of 59-1/2, they'd have to pay a penalty.
Finally, don't think of this as a tool for estate, Davis cautions. "For some families, it makes more sense to use trusts, family limited partnerships, and other advanced planning techniques when considering generational wealth matters."
Custodial IRAs vs. UTMA/UGMAs
Custodial investment accounts like UGMA/UTMAs are brokerage accounts for parents to invest on behalf of a child or minor. But unlike the funds in a custodial IRA — which are designated as retirement savings — money in a UTMA/UGMA can be used for virtually anything, including college tuition, rent, travel, and other expenses.
UTMA and UGMAs also have no income limits or contribution limits. Moreover, as long as the its for the direct benefit of the minor, parents can withdraw funds from a UTMA/UGMA at any time. The child gets full control over the account once they reach the age of maturity.
If you want to save for your kid's retirement specifically, a custodial IRA is by far the better option. Plus, these accounts may offer more growth potential and better tax advantages. But you'll be limited to contributing the amount of a kid's earned income up to $7,000 in 2024.
UTMA/UGMAs, on the other hand, are more flexible and have no contribution limits. Friends and family can even contribute money (aka a gift) as a way to boost savings. But contributions may not be tax-deductible. A UTMA/UGMA can also affect your child's ability to qualify for financial aid.
Why you should open a Roth IRA vs. traditional IRA for kids
You can adopt this strategy with a traditional IRA, too. But the Roth version makes more sense for young people for three reasons:
- The child will not likely earn enough to pay substantial income taxes. So, getting to deduct the contribution when you make it — one of the big advantages of the traditional IRA vs. a Roth — doesn't mean as much.
- With Roth IRAs, withdrawals are 100% tax-free after age 59½, when your child is likely to be in a higher tax bracket than they are now.
- Overall, Roth IRAs are more flexible. You can withdraw Roth IRA contributions (but not investment earnings) at any time, tax-free and penalty-free. That means the child could conceivably use some of the IRA money for big expenses in young adulthood, such as college costs or a first-time home purchase. Some of these may qualify for exceptions that let you use earnings, too.
Another thing to remember is that, unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) when you reach a certain age. That means the account can continue to grow for an entire lifetime, making it an ideal wealth-transfer vehicle.
How to open a custodial Roth IRA
If you're ready to set up a Roth IRA for a child, the first step is to contact an account with one of the best online brokerages that offers Roth IRAs for minors.
You must provide their Social Security number because the account is opened in the child's name. Some brokerages that offer IRAs for minors include:
Child IRAs work the same way as the best IRA accounts as far as the IRS is concerned. But depending on the broker, the kid version may have a lower minimum deposit requirement. Fidelity, for example, completely waives the minimum requirement.
Are custodial Roth IRAs worth it?
A custodial Roth IRA is worth it for families looking to start long-term savings for a child or minor. Not only do custodial Roth IRAs provide tax-free growth and withdrawals, but it also have the chance for substantial growth with the power of compounding.
That said, a Roth IRA for kids doesn't offer an initial tax break, and funds can't be withdrawn until the child is at least age 59 1/2. If you want to save for other expenses outside of retirement (college tuition, buying a house, wedding, etc.), then a UTMA/UGMA or a 529 plan may be better.
Consult a financial advisor such as a fiduciary or CFP for personalized advice on investing and retirement savings.
Custodial Roth IRAs — Frequently asked questions (FAQs)
What is a custodial IRA?
A custodial IRA is a tax-advantaged retirement savings account that a parent/guardian can open on behalf of a child/minor but is funded by the child's earned income. Custodial IRAs can be opened as either a Roth or a traditional retirement plan. IRAs for kids also follow the same rules and contribution limits as regular IRAs.
At what age can you start a Roth IRA?
You can open a Roth IRA at any age through a qualifying brokerage or investment platform. Even a baby can open a custodial Roth IRA as long as it has an earned income.
Is a custodial Roth IRA a good idea?
A custodial Roth IRA can be a good idea for parents to start saving for their child's retirement. The longer the money is in a Roth IRA, the more the funds can grow from compound interest and long-term investing strategies. However, a Roth IRA for kids isn't the best idea if you want to save for education expenses or short-term goals.
What is the income limit for a custodial Roth IRA?
You can only contribute as much as the child's annual earned income to a custodial Roth IRA in 2024. For example, if a child earned $3,000 in a given year by working part-time at a convenience store, then you can only contribute up to $3,000 into a custodial Roth IRA.
How do I prove my child's income for a Roth IRA
You can prove your child's earned income for a Roth IRA with a W2 or a Form 1099. However, certain work like babysitting or mowing lawns technically doesn't provide these forms, so it's important to keep a record of the type of work the kid has down, when it took place, who it was for, and how much the kid was paid.