Custodial Roth IRA: Unlock the power of tax-free growth for your kid
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- You can open a custodial Roth IRA for a child as long as that child has earned income.
- Anyone can contribute to the account as long as the contributions don't exceed the child's earned income.
- A custodian controls the custodial Roth IRA until the child reaches majority age.
It's never too early to start saving for your child's future. Kids have decades ahead of them to save for retirement, which puts them in the prime position to take full advantage of long-term investment strategies and the power of compounding with some of the best Roth IRA accounts.
IRAs are one of the best custodial accounts to set up for your kid. Custodial Roth IRAs are among the strongest tax-advantaged savings vehicles for growing long-term wealth through risk-adjusted investment opportunities and compound interest.
Learn how to open a custodial Roth IRA and the tax advantages your kid can earn.
What is a custodial Roth IRA?
Definition and overview of custodial Roth IRAs
A custodial Roth IRA is a tax-advantaged retirement account for children with earned income to contribute after-tax dollars. Investing funds from a young age boosts the growth potential of your child's nest egg and promotes financial freedom later in life.
Saving and investing are key components of long-term wealth. Unfortunately, "most Americans lack the discipline to save an adequate amount as a percentage of their income," says Sam Davis, RIA and managing member at TBH Advisors. "So, inspiring savings early in a child's life can really help."
The money invested and compounded in a custodial Roth IRA grows tax-free. Your child also gets the additional benefit of tax-free withdrawals during retirement. Keep in mind that this money can't be withdrawn until the child is at least 59½.
If you want to save for other expenses outside of retirement (college tuition, buying a house, wedding, etc.), then an UTMA/UGMA or a 529 plan may be better.
How it differs from a regular Roth IRA
Roth IRAs are among the best IRA accounts for individuals to grow their retirement savings. A custodial Roth IRA is no different, as it includes the same tax benefits, investment opportunities, and limitations as regular Roth IRA accounts.
Regular IRA contribution limits apply, but with the additional rule a parent or guardian can't contribute more than the child's annual earned income. So, if your daughter earns $3,000 by babysitting this calendar year, you can only contribute up to $3,000 to her custodial Roth IRA. The maximum contribution to a Roth IRA is $7,000 in 2024.
Otherwise, the main difference between regular Roth IRAs and a custodial Roth IRA is that a parent or guardian invests and manages the account's contents until the child reaches the age of majority (18 or 21, depending on the state). Afterward, the account and all investment decisions are turned over to the designated beneficiary.
Benefits of a custodial Roth IRA
Custodial Roth IRA tax benefits
Custodial Roth IRAs provide several benefits, including tax advantages. Since Roths are funded with after-tax dollars (already taxed money), earned interest and capital gains grow tax-free. Custodial Roth IRA withdrawal rules are the same as regular Roth IRA withdrawal rules, meaning the account beneficiary won't pay tax when withdrawing during retirement.
Tax-free withdrawals are especially beneficial for people who believe they will be in a higher tax bracket during retirement than during their working years.
"It's a great way to help educate their kids on the savings process while investing tax-efficiently," says Davis.
Flexibility for future use
Custodial IRAs are under the child's control once they turn 18 or 21, relieving them of some of the financial pressure younger workers often feel toward the beginning of their careers. Many people struggle to regularly save for long-term goals like retirement while balancing loan repayments and affording basic life expenses.
However, an already-established Roth IRA can give your kid a leg up, as the funds will continue to grow due to interest and investment opportunities. Your child may be in a better financial situation to pay off their loans or create additional savings buckets for other financial goals, like a future wedding or buying a home.
Roth IRAs can also double as emergency funds. In a pinch, the original contributions (excluding the growth) can be withdrawn tax and penalty-free as long as the account is at least five years old. If they were to withdraw earnings from the IRA before they reach the age of 59 1/2, they'd have to pay a penalty.
Long-term growth potential
Setting up a Roth IRA for your kids now can help them secure a comfortable retirement later. The longer the money is in a Roth IRA, the more the funds can grow. A single $7,000 investment made today could be worth more than $300,000 in 50 years, assuming an 8% annual return.
Typically, younger investors are the best candidates for riskier investment opportunities. Riskier investments may yield higher returns with an increased chance of a substantial loss. However, younger investors are the best candidates for risky investments since they have the time to recover from potentially failed investments.
Custodial Roth IRA eligibility and requirements
Who can contribute to a custodial Roth IRA?
According to the IRS, children must have earned income to contribute to a Roth IRA. Earned income can come from entrepreneurial activities like babysitting, mowing lawns, dog-walking, wages from a job, tips, or prize money. Allowances do not count as earned income.
Anyone can contribute to your child's Roth IRA as long as the child beneficiary has earned income. The parent or guardian acting as the account's custodian can contribute, as can grandparents, friends of the family, and other relatives.
Custodial Roth IRA income requirements
Typically, you aren't eligible to contribute to a Roth IRA if you make $161,000 or more annually in 2024 ($240,000 if you're married). But in this case, your income threshold doesn't matter. The only income the IRS cares about is the child's.
One potential drawback of a Roth IRA for kids is that your child may eventually make too much money to continue funding the account. That's not necessarily a bad position to be in, as the account will continue to grow tax-free even without additional contributions.
Custodial Roth IRA contribution limits
In 2024, you can only contribute as much as the child's annual income, so your child must have garnered at least $7,000 to make a full contribution in 2024.
"One idea that we've seen families implement that seems to be a good motivator is to implement matching funds," says Davis. "Only invest for a child what they are willing to invest themselves." So, for example, if your kid is willing to sock away $3,000, you can kick in another $3,000 to max out the contribution.
You can prove your child's earned income for a Roth IRA with a W2 or a Form 1099. However, certain work like babysitting or mowing lawns technically doesn't provide these forms, so it's important to keep a record of the type of work the kid has down, when it took place, who it was for, and how much the kid was paid.
How to set up a custodial Roth IRA
If you're ready to open a custodial Roth IRA for a child, the first step is to contact an account with one of the best online brokerages that offers Roth IRAs for minors.
You must provide their Social Security number because the account is opened in the child's name. Some brokerages that offer IRAs for minors include:
Depending on the brokerage, the kid version may have a lower minimum deposit requirement. Fidelity, for example, completely waives the minimum requirement for minors.
Davis cautions against using custodial Roth IRAs as an estate planning tool. "For some families, it makes more sense to use trusts, family limited partnerships, and other advanced planning techniques when considering generational wealth matters."
Custodial Roth IRA investment options
An IRA isn't an investment in itself. Rather, IRAs are the accounts that hold your chosen investments. Part of the responsibility of opening and managing a custodial Roth IRA is investing the money in different asset classes. Again, this is your job as a custodian until the child is old enough to take over.
With your custodial Roth IRA, you can invest in assets such as:
- Stocks
- Bonds
- ETFs
- Mutual funds
- Money market funds
- Alternative investments and commodities
Why you should open a Roth IRA vs. traditional IRA for kids
You can also adopt a similar long-term investment strategy with a traditional IRA. But the Roth version makes more sense for young people for three reasons:
- The child will not likely earn enough to pay substantial income taxes. So, getting to deduct the contribution when you make it — one of the big advantages of the traditional IRA vs. a Roth — doesn't mean as much.
- With Roth IRAs, withdrawals are 100% tax-free after age 59½, when your child is likely to be in a higher tax bracket than they are now.
- Overall, Roth IRAs are more flexible. You can withdraw Roth IRA contributions (but not investment earnings) at any time, tax-free and penalty-free. That means the child could conceivably use some of the IRA money for big expenses in young adulthood, such as college costs or a first-time home purchase. Some of these may qualify for exceptions that let you use earnings, too.
Another thing to remember is that, unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) when you reach a certain age. That means the account can continue to grow for an entire lifetime, making it an ideal wealth-transfer vehicle.
Custodial IRAs vs. UTMA/UGMAs
Custodial investment accounts like UGMA/UTMAs are brokerage accounts for parents to invest on behalf of a child or minor. But unlike the funds in a custodial IRA — which are designated as retirement savings — money in a UTMA/UGMA can be used for virtually anything, including college tuition, rent, travel, and other expenses.
UTMAs and UGMAs also have no income or contribution limits. Moreover, as long as the withdrawal is for the direct benefit of the minor, parents can withdraw funds from a UTMA/UGMA at any time. The child gets full control over the account once they reach the age of maturity.
A custodial IRA is the better option if you want to save for your kid's retirement. Plus, custodial IRAs more greater growth potential and better tax advantages. But you'll be limited to contributing the amount of a kid's earned income (up to $7,000 in 2024).
Custodial Roth IRA FAQs
What is a custodial Roth IRA?
A custodial Roth IRA is a retirement savings account opened on behalf of a minor and managed by a parent or guardian until the child reaches adulthood. The child must have earned income to contribute. Standard Roth withdrawal rules, contribution limits, investment opportunities, and tax advantages apply to custodial Roth IRAs.
Who can open a custodial Roth IRA?
Anyone is eligible to open a custodial Roth IRA. Parents or legal guardians can open a custodial Roth IRA for a minor if the minor has earned income, but can only contribute as much as that annual earned income.
What are the tax benefits of a custodial Roth IRA?
The tax benefits of a custodial Roth IRA are the same as those of a regular Roth IRA account. Roth IRA contributions are made with after-tax dollars, offering investors tax-free growth and withdrawals during retirement. If you're looking for tax-deferred growth, consider a traditional custodial IRA instead.
When can funds be withdrawn from a custodial Roth IRA?
Funds can technically be withdrawn from a custodial Roth IRA at any time. However, only original contributions can be withdrawn penalty-free and tax-free for investors younger than 59½. Both contributions and earnings can be withdrawn from a custodial Roth IRA once the account owner turns 59½ and the account has been open for at least five years.
What happens to the custodial Roth IRA when the child reaches adulthood?
The child listed as the custodial Roth IRA beneficiary is given full control over the account upon reaching adulthood. Parents or guardians who originally opened the account no longer have a say in how the funds are invested or managed.