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Set Up Custodial Roth IRAs for Your Kids Now, They'll Thank You Later

Every parent’s goal is to see their child lead a life full of health, happiness, and financial success. While they’ll grow up and make their own choices, what you do now sets the stage for the next several decades. There’s no shortage of options to enhance your child’s financial future, but have you considered a custodial Roth IRA?

Many parents set up a savings account for their child, and building a college fund with a 529 account is also common. While people usually think of IRAs as something to deal with once you’ve started your career, they’re a great way to start saving early in life.

So what’s the deal with custodial Roth IRAs? Read on to find out how they work and how the benefits compare to other options.

What Is a Custodial Roth IRA?

You may have seen advertising for “Roth IRAs for kids” or similar products. Typically, they’re referring to a custodial IRA. The rules for a custodial Roth IRA are much like any other Roth individual retirement account, at least from a tax standpoint. 

The only difference is that, since your child is a minor, you’ll have to open it in their name. As the custodian of the account, you’ll be in charge of it and make all the investment choices for them. Once your child turns 18, you can turn control over to them.

While you could also open a custodial traditional IRA, the tax implications generally don’t make sense. Roth IRAs are advantageous if the account holder will be in a higher tax bracket when they start withdrawals. And unless your seven-year-old child is the world’s youngest investment banker, it’s a safe bet they’ll be earning more later in life.

How to Open and Fund a Custodial Roth IRA

Opening a custodial IRA for minors is as easy as creating a savings account for them. Simply choose a financial partner that offers custodial accounts. Provide your child’s name and social security number, and make an initial contribution.

From there, you, your child, or anyone else can make contributions to the IRA. There are a couple of limits, though:

  • Like any other IRA, you can’t contribute more than $6,000 per year.
  • More importantly, the contributions can’t exceed your child’s earned income for the year.

Limiting the contributions to “earned income” might sound overly restrictive—after all, most kids aren’t working normal jobs—but the IRS guidelines on earned income are quite broad. The most important aspect is to have documentation supporting the income, but here are a few examples:

  • Teenagers working W2 jobs—such as in a restaurant or grocery store—will have all the documentation they need. Saving pay stubs is never a bad idea, but their year-end tax forms are an easy way to prove income.
  • Younger kids might work odd jobs around their neighborhood, such as mowing neighbors’ lawns, dog walking, or babysitting. In this case, you’ll want to make sure your child has some sort of receipt to prove when they performed the work, for whom, and how much they earned.
  • If you have a family business, you can pay your child to do appropriate tasks for reasonable pay. That last bit is important, as the wages have to make sense for the job. Paying them $100/hr to make photocopies won’t stand up to scrutiny.

Benefits of Custodial Roth IRAs for Retirement Planning

It might seem premature to start retirement planning for a young child, but it’s never too early. Long-term financial planning is the cornerstone of a secure and comfortable future.

While any form of saving is better than none, custodial Roth IRAs offer some big benefits compared to other options:

  • Flexible withdrawals - 529 accounts are great ways to save for higher education, but not much else. Custodial Roth IRAs have far more flexible withdrawal options. Since you contribute with post-tax funds, you—or your child—are free to withdraw contributions at any time, and for any reason. And as long as the account has been open for at least five years, you can withdraw the earnings without any penalties or taxes, too.
  • Investing beats saving - Emergency funds are a critical part of any retirement plan, but children don’t usually need to pay for car repairs or a surprise dental procedure. Opening a savings account for them would only pay out fractions of a percent in earnings. While putting their IRA into the market means it could drop with a recession, the timeline until they need it is long enough that the benefits outweigh the risks.
  • Easy to set up and manage - There are no complex rules to navigate. Once you’ve opened your child’s custodial Roth IRA and made an initial contribution, there’s minimal ongoing maintenance. Periodically rebalance the portfolio, as you would for your own IRA, or you can select a low-fee target-date fund appropriate for your child’s age.
  • Tax advantages - Most kids and teenagers won’t earn enough money to owe any taxes. However, any contribution that goes into their custodial Roth IRA is post-tax money, so all withdrawals—both principal and earnings—are tax-free. Effectively, they won’t pay any taxes on the money going in, nor on the money coming out.

Preparing Your Kids for Financial Success

The best foundation for a secure retirement is an early start to investing. Opening a custodial Roth IRA for your child builds wealth, but it has other advantages, too. As they reach adulthood, involving them in account management is a good way to build financial literacy. And as they navigate their 20s, the flexibility to make withdrawals for college or their first house can help build their ideal future.

If you have any questions about how to manage a custodial Roth IRA, or how it fits into their future, a fiduciary financial advisor can help. Fiduciaries are bound by a legal oath to act in their clients’ best interests and can explain everything you need to know to set your child up for a secure future.

Are you prepared to retire happy, vibrant, and free?  Find out the answer and more with our FREE 2022 Essential Retirement Guide. 

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For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third-party data which may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are unmanaged baskets of securities and are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends and capital gains. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements, or representations whatsoever by us regarding third-party websites. Wealth Legacy Institute is not responsible for the content, availability, or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products, or services available on or through these third-party websites. The opinions expressed by featured authors are their own and may not accurately reflect those of Wealth Legacy Institute®.


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