As parents, we want to give our children every financial advantage possible. One way to do this is by opening a custodial Roth IRA. With a custodial Roth IRA, you can help your children start saving for retirement as soon as they begin earning income.
Roth IRAs for kids are a great retirement tool, because children have decades for their contributions to grow tax-free, and contributions can be withdrawn without penalty at any time. Plus, when your child reaches retirement age, they will have a tax-free source of income to supplement their other retirement savings.
In this article, we'll explain how a custodial Roth IRA works, how it differs from a traditional IRA, and the benefits of opening one for your child.
What is a Custodial Roth IRA?
A custodial Roth IRA is an individual retirement account that is set up for a minor child. The account is managed by a custodian (usually a parent or guardian) until the child reaches the age of majority in their state (usually 18 or 21). At that point, the child becomes the account owner and can manage the account themselves.
How Does a Custodial Roth IRA Work?
A custodial Roth IRA works much like a traditional Roth IRA. Contributions are made with after-tax dollars, and the money grows tax-free. However, there are some important differences to keep in mind:
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Contribution Limits: The annual contribution limit for a custodial Roth IRA is the same as for a traditional Roth IRA ($6,000 in 2021, or $7,000 if you're 50 or older). However, the amount your child can contribute is limited to their earned income for the year.
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Required Minimum Distributions (RMDs): With a traditional IRA, you must start taking RMDs at age 72. However, with a Roth IRA, there are no RMDs during the account owner's lifetime. This means that your child can let the money grow tax-free for as long as they like.
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Withdrawals: Contributions can be withdrawn at any time without penalty. However, earnings can only be withdrawn tax-free if the account has been open for at least five years and the account owner is at least 59 1/2 years old.
Why Open a Custodial Roth IRA for Your Child?
There are several benefits to opening a custodial Roth IRA for your child:
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Tax-Free Growth: A custodial Roth IRA allows your child's contributions to grow tax-free over many years. This can result in a significant amount of tax-free income in retirement.
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Generational Wealth: Opening a Roth IRA for kids with earned income is a powerful way to create generational financial stability. Your child can continue to contribute to the account throughout their working years, and they can also pass the account on to their own children.
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Financial Education: A custodial Roth IRA can be an excellent way for children to learn about investing. By managing their own account, they can learn valuable lessons about saving, investing, and the power of compound interest.
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Flexibility: With a Roth IRA, your child has the flexibility to withdraw their contributions at any time without penalty. This can be especially useful if they need to access the funds for a large purchase, such as a down payment on a house.
How to Open a Custodial Roth IRA
Opening a custodial Roth IRA is relatively simple. Here are the steps you'll need to follow:
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Choose a Custodian: You will need to choose a custodian to manage the account on your child's behalf. This can be a bank, brokerage firm, or other financial institution.
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Gather Documents: You will need to provide the custodian with your child's Social Security Number, birth certificate, and proof of income.
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Complete the Application: You will need to complete an application to open the account. This will include information about the account owner (your child) and the custodian (you).
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Make Contributions: Once the account is open, you can make contributions on behalf of your child. Be sure to keep track of the amount contributed each year, as it cannot exceed their earned income.
Leaving an IRA to a Minor
If you want to leave an IRA to a minor, you'll need to understand how your gift will be distributed, managed, and taxed. Here are some things to keep in mind:
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Custodial IRA: If you want to leave an IRA to a minor, you can set up a custodial IRA. The account will be managed by a custodian until the child reaches the age of majority.
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Beneficiary Designation: You can also name a minor child as the beneficiary of your IRA. In this case, the account will be managed by a custodian until the child reaches the age of majority.
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Taxation: If your child inherits a traditional IRA, they will be required to take RMDs based on their life expectancy. These distributions will be taxed as ordinary income. If they inherit a Roth IRA, they can take tax-free distributions for the rest of their life.
Conclusion
A custodial Roth IRA can give your child a financial advantage down the line. By starting to save for retirement early, your child can take advantage of tax-free growth and create generational wealth. Plus, managing their own account can be a valuable learning experience. If you're interested in opening a custodial Roth IRA for your child, be sure to do your research and choose a reputable custodian to manage the account.
