Saving for your child’s future from an early age gives them a significant boost to reach their financial goals down the road. While a savings account helps them earn a little extra money, opening a custodial Roth IRA can provide longer-term financial stability.
While your child’s retirement may be the last thing on both your minds, opening a custodial Roth IRA for your child now actually has many benefits like tax advantages and long-term savings.
What is a Custodial IRA for kids
A custodial IRA is a retirement savings account set up for a minor child by a parent, grandparent, or legal guardian. The child is the account owner, but an adult manages the account.
The child takes control and transfers the retirement account when they reach adulthood, which is usually between the ages of 18 and 21, depending on where they live.
Aside from the management responsibility, a custodial account works pretty much the same way as an IRA you would open for yourself. Your minor child must have earned income to be eligible for a custodial IRA. Amounts contributed are subject to the same IRS limits.
Custodial Roth IRAs vs Traditional IRAs
You can also choose between a custodial traditional IRA or a Roth IRA. You contribute pre-tax dollars to traditional IRAs and pay taxes upon withdrawal, while Roth IRAs grow tax-free. Usually, a custodial Roth IRA is more advantageous from a tax perspective.
Custodial Roth IRA rules
With a custodial Roth IRA, you make contributions on your child's behalf with after-tax dollars. Investments grow tax-free. The basic rules around custodial Roth IRA accounts include:
Earned income
As long as your child has earned income, they may contribute toward a custodial Roth IRA. A child can contribute to a custodial Roth IRA, whether they have a summer job or earn money with side gig work, like babysitting or cutting grass. You can employ your own child, but make sure the payment is fair for the work.
Contribution limits
Custodial Roth IRA contributions are limited to your child’s earnings or the annual IRS limit of $7,000 in 2024, whichever is less. If your child earned $3,000 babysitting for the year, they may contribute up to $3,000 toward their Roth IRA.
To motivate your child, you may also contribute to their account, subject to the limits above. So, if your child earns $3,000 but only wants to contribute $1,000, you may contribute up to $2,000 to their account.
No minimum age requirement
You can open a custodial Roth IRA regardless of your child’s age if they earn income. So, if your toddler earns $8,000 from a modeling gig, you may open and contribute up to $7,000 (the IRS limit for 2024) to their custodial Roth IRA.
Withdrawal limits
A custodial Roth IRA account lets your child save toward retirement. Once your child reaches adulthood, they can roll their balance into a regular Roth IRA. The ability to withdraw contributions early for any purpose without penalty is a nifty feature of a Roth IRA. So, your child may withdraw money to pay for college expenses or a car if needed.
Remember, only contributions may be withdrawn penalty- and tax-free. Any income earned on the investments may be charged a 10% penalty if withdrawn before age 59 ½.
How to open a Custodial Roth IRA for kids in 4 steps
Confirm your child meets the criteria before taking steps to open a custodial Roth IRA.
Step 1: Choose a provider
Your first step is to choose a financial provider. You may already work with a broker or financial institution, such as Fidelity or Charles Schwab, that offers a Roth IRA for kids. You could also seek an online custodial IRA provider, such as eTrade.
When narrowing down your choices, look at the fees charged. You could open a custodial Roth IRA at Fidelity with no minimum balance requirement and no account fees.
Step 2: Open the account
You need to provide basic data for both you and your child when opening a custodial Roth IRA. Most institutions ask for Social Security numbers, banking information, annual income, and employment information.
You may open a Roth IRA for kids online at Fidelity. If you are a client of Charles Schwab, you may upload the custodial IRA application if you have online access to your accounts. If not, you can mail, fax or bring the completed application to your nearest branch.
Step 3: Determine how much to contribute
An initial deposit is necessary to open the account and start investing. Your child may not want to deposit all their money, so it’s a good idea to talk with them about how much to contribute.
Step 4: Invest contributions
Once you fund the account, you can begin investing. Many financial institutions let you choose between stocks, mutual funds and ETFs.
Why open a Custodial Roth IRA?
If you are wondering if a custodial Roth IRA is a good financial choice, consider the many benefits of this retirement vehicle.
Advantages of opening a Custodial Roth IRA
- Time: The single biggest factor that compounds investment returns is time. Your child has a greater opportunity to grow their retirement fund the earlier they start. A child who contributes to a custodial Roth IRA at an early age could build up a sizeable fund by the time they hit retirement age.
- Investing vs. Saving: With a custodial Roth IRA, you invest in stocks, mutual funds and exchange-traded funds (ETFs) to build future wealth. Conversely, savings help prepare for emergencies and meet short-term financial goals.
- Tax Advantages: Investments grow tax-free. Your child pays no tax on qualified distributions once they reach retirement age. Unlike traditional IRAs, Roth IRAs have no required minimum distributions.
- Flexibility: Even though a Roth IRA is a tax-advantaged retirement account, the funds contributed can be withdrawn tax and penalty free. So, if your child has a pressing financial need down the road, such as a down-payment on a home or college tuition, they have a substantial nest egg to use. Earnings, however, may be taxable if taken out before the age of 59 ½.
- No impact on financial aid eligibility: Funds in retirement accounts are not be counted for college financial aid eligibility.
What happens when your child turns 18?
Once they reach adulthood, your child should take steps to transfer the custodial Roth IRA to another account in their name. The financial institution will likely require your child to apply to make this transfer.
Use a custodial Roth IRA to build your child's future
Investing toward your child’s retirement through a custodial Roth IRA can be a great idea as they start to earn income. Thanks to compounded earnings, your child can watch their investment grow over time. Your child still has access to the contributions, providing a financial cushion to use for school or a downpayment on a home. However, if your child keeps the funds intact, they benefit from financial stability as they head into retirement.
FAQs
Can parents fund a child's Roth IRA?
A parent may fund their custodial Roth IRA if a child has earned income. However, contributions are limited to the lesser of the child’s income or the IRS limit ($7,000 in 2024).
What is the difference between a custodial Roth IRA and a traditional IRA?
You make contributions with post tax money with a custodial Roth IRA. Since your child received no tax benefit, they may withdraw contributions at any time without penalty. Similarly, a traditional IRA is a tax-advantaged account, however you contribute pre-tax dollars. Until your child reaches retirement age, they cannot withdraw funds without paying penalties or income tax.
Can I open a custodial Roth IRA for my baby?
Even at a young age, custodial Roth IRAs may be opened for children who earn income. If your baby earns money modeling clothes, you can open a retirement account on their behalf.