While most commonly used as a tax-efficient way to save for retirement, Roth IRAs have some unique traits that make them appealing to investors with many financial goals.
In particular, opening Roth IRAs for your minor children may help them get a jumpstart on their financial future.
Wait, you can open a Roth IRA for your kids?
Investing in a Roth IRA for your kids may open up some critical future opportunities—far more than a piggy bank could provide.
- So how exactly do Roth IRAs work?
- What are the rules you must follow to stay in compliance with the law and avoid costly taxes and penalties?
- What are the benefits of opening these types of accounts for your children?
Let’s find out!
The Basics of Roth IRAs
In their most basic form, Roth IRAs are individual retirement accounts that allow you to contribute after-tax money earmarked for tax-free retirement income.
Here’s how it works:
- Contribute after-tax dollars to the account.
- Invest the money in the market (stocks, bonds, mutual funds, exchange-traded funds, etc.).
- Let the money grow tax-free for an extended period (until retirement after age 59 1/2).
- Withdraw the money tax-free to supplement retirement income needs.
But Roth IRAs are unique, flexible investment vehicles that can provide several benefits before retirement as well. To take full advantage of this account, you must understand the rules.
Roth IRA Rules For Kids
To open a Roth IRA on behalf of your child, you should consider a few rules and characteristics unique to minor children.
- Earned Income: Kids of any age may have a Roth IRA so long as they have earned income. To contribute, your child must have earned income equal to or greater than the amount of the contribution in a given tax year. These same rules apply to adults.
- Custodian: A minor child with a Roth IRA must have a custodian for the account (i.e., their parents). This custodian is responsible for investing the account on behalf of the child and maintains complete control over the account. Keep in mind that the money technically belongs to your children when they reach the age of majority. So they could use the money for college, save it for retirement, or blow some of it on new gaming equipment. It’s important to teach your kids the value of money and how investing long-term can set them up for success.
- Contribution Limits: Similar to the rules for adults, the max contribution on a Roth IRA for a minor child is $6,000 per year for 2022.
- Matching Contributions: Can you contribute to the account on their behalf? Yes, if you follow the rules. Parents and family members are permitted to “match” contributions to the child’s Roth IRA (so long as the total contributions do not exceed the greater of the child’s income and the $6,000 annual limit). For example, if your child earns $10,000 at a part-time job and contributes $3,000 to their account, you may contribute $3,000 from your own funds. It’s important to note that your personal contributions will count towards the annual gift tax limit.
Now that you know how the process works, why would you want to consider this avenue in the first place?
5 Benefits of Roth IRAs for Kids
Roth IRAs offer innumerable benefits, and with most investments, the earlier you start, the better! Here are just a few strong reasons why a Roth IRA could be a fantastic investment for your kids.
- Jumpstart on Retirement: The most noticeable benefit is getting an early start on retirement savings. With so many kids coming out of college with insurmountable student loan debt and a difficult job market, your child will stand to benefit from saving at an early age.
- Access to Contributions: Regardless of the growth in the account over time, your child will always have access to any amount contributed to the account (tax and penalty-free). For example, if contributions total $20,000 but the account is now worth $30,000, the first $20,000 of withdrawals would be tax and penalty-free. This flexibility allows them to use the fund should they need to.
- Qualified Education: Roth IRAs can be used to pay for qualified education, like tuition, fees, room and board, etc. The earnings are not subject to the 10% penalty typically associated with early withdrawals. Remember that IRA distributions count as income on the FAFSA, so be strategic with your withdrawals. Check out our free College Money Report to help you financially prepare for college.
- First-Time Home Buyers: Once the account has been open and active for at least five years, your child may use up to $10,000 in earnings to buy their first home (tax and penalty-free).
- Business Owner Benefits: For business owners, it can be easier for a child to have earned income by “hiring” them to do work (i.e., file paperwork or shred old files) so that they have the eligible income to contribute to a Roth IRA. Their earned income (or salary) will also serve as a business expense to offset business earnings.
Opening a Roth IRA for your kids also serves as a teachable moment. Teaching your children about money is a lifelong exercise, and this can be an opportunity to teach them the meaning of compounding interest, the value of long-term investing, and saving for their future.
How Our Team Can Help
If your child qualifies, a Roth IRA can benefit their financial future and spark financial conversations about savvy saving and investing. With that said, it can be difficult to structure your strategy in a way that is both legal and beneficial to your children.
At Chladek Wealth, we help our clients navigate a complex financial system and set them (and their children) up for long-term financial well-being. Schedule some time with us today. We can’t wait to help!
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article. All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.