Most people do thin think of a Roth IRA as a way to save for their children’s future. 529 plans are popular but don’t come close to the advantages of using a Roth IRA.
- No age restrictions
- Contributions grows tax-fee
- Contributions can be withdrawn at any time without any penalty or tax.
What is a kid’s Roth IRA or a custodial Roth IRA?
A custodial Roth IRA is a retirement account a parent/guardian opens for a child. When you open the kid’s Roth IRA, you name yourself as the custodian and your child as the beneficiary. This unique retirement account for a minor allows them to contribute to the account and start enjoying the benefits of tax-free compounding early on.
Roth IRA for Kids: The 3 Rules
There’s no age limit for opening a Roth IRA for kids. However, you have to follow certain rules that include:
- Your child needs earned income: If your kid is working as a babysitter or earns money by doing chores such as lawn mowing or walking the dog, they can contribute to a Roth IRA.
- There are contribution limits: The kid’s Roth IRA has the same contribution limits as an adult Roth IRA. This means for 2023, the maximum contribution for account holders under 50 is $6,500.
However, the contribution cannot be more than your child’s income. So if your child earns $2000 in a year, the maximum they can contribute is $2000, regardless of who contributes.
Their age doesn’t matter: Roth IRA eligibility for kids is based on income and not their age.
What if the child is too young to have income? Think about this scenario – we have been teaching this for years. Have an older relative – Uncle or Aunt (who have earned income) open a Roth IRA in their name but name the child as the beneficiary. Let’s have some fun and pretend we have two sets of Uncles and Aunts. Assuming they are over 50, they can contribute $6,500 each (4 X $6,500 = $26,000)! As the children get older and need some money, Uncle or Aunt takes a tax-free distribution and gifts it to the child. What if the worse happens and the Uncle passes away – the child inherits a seasoned Roth IRA!
How to open a Roth IRA for your kids?
Opening a Roth IRA for kids is a simple process. You can open one at the bank or through a brokerage firm. Although your child’s income makes them eligible for Roth IRA, you need to open and manage a custodial Roth IRA on their behalf.
You’ll need your and your child’s Social Security numbers, banking information, birthdates, and other personal information.
Why is a Roth IRA ideal for kids?
Now that you know that your kid can have a Roth IRA, you might wonder whether they should. We’ll list a few reasons why Roth IRA is a good choice for your children:
- Withdraw contributions any time: Most retirement accounts charge a 10% early withdrawal fee for taking out money before age 59½. But contributions made to a Roth IRA for kids can be withdrawn at any time and used for anything.
- Enjoy the power of compound growth : When the kid starts investing early on, they have decades to reach their retirement. This means the invested money, if left in Roth IRA, grows tax-free until the child reaches the retirement age.
- Better growth than a savings account: A savings account cannot offer the kind of growth that a Roth IRA offers. A Roth IRA allows your child to select investments that can provide significant growth over the long term. In comparison, a savings account pays a flat interest rate which is currently hovering at 0.09%.
- Prime tax advantages: There is no tax break for making contributions into a Roth IRA for kids, and the qualified distributions at retirement are not taxed. So, all the growth that happens in a Roth IRA is completely tax-free as long as all the distribution rules are followed.
- Use the money for retirement and more: Although Roth IRA is a retirement account, it isn’t just that. You can pull your contributions at any time for any reason. Once the Roth IRA is funded for five years, your child can withdraw earnings of up to $10,000 to buy a first home without paying any tax or penalty. Moreover, the earnings can be used for education expenses. However, earnings distributed are taxed as income, but no penalty is applied.Some of the ways a Roth IRA can be used include:
- – Emergency fund
- – A funding source for college expenses
- – Down payment on your child’s first home
Help your child become a millionaire!
The Roth IRA offers many perks that a child can enjoy before retirement, but if the money is left in the account, it grows substantially over time to make your child a millionaire.
For example: If your child earns money as a model, and you decide to open a child IRA at age 13. The account is funded with $6,500 every year by contributions made by your child or you. Assuming that the annualized interest rate is 7% and there are no withdrawals made, your child’s nest egg becomes more than $1 million even before they turn 55. If your child waits until they reach 59 1/2, every penny of that million-dollar Roth IRA account is tax-free.
By opening a Roth IRA for kids, you are helping your child to start planning for retirement early on. Additionally, your child will get all the benefits that an adult Roth IRA offers, including tax-free growth on investments and tax-free withdrawals in retirement.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.