Written by: Derek Melvin
A question we sometimes get from parents is, "Can I contribute to a Roth IRA for my child?" When thinking about saving money for a child’s future, there are many options. These can include a simple savings account, a college savings plan, or some may even use a piggy bank. One savings option that is not considered as often is a Roth IRA (Individual Retirement Account), which can be a tax advantageous way to jumpstart their long-term savings.
What is a Roth IRA?
A Roth IRA is a tax-deferred investment account that allows you to make tax-free withdrawals once you are over age 59.5. Contributions to the account are with after-tax dollars and any qualified withdrawals are completely free of tax – even the gains in the account. This makes a Roth IRA attractive to long-term investors, as the contributions invested within the account can grow tax-free.
Roth IRA Qualifications for a Minor
Roth IRA’s allow for a minor to open an account with an adult as the custodian. However, there are some qualifications that need to be met to contribute into the account.
- There are no age restrictions, only restrictions with regards to their income.
- You can open a custodial Roth IRA for your child of any age; however, the child must have earned income in the year in which the contributions are made.
- The child must have IRS taxable income to make contributions.
- There are contributions limits.
- The contribution limit in 2021 for a Roth IRA is $6,000 or total earned income for the year, whichever is less. Therefore, if your child’s income is less than $6,000, you would only be able to contribute up to their total earned income for the year.
The income must be legitimate income at a legitimate wage base. You can’t pay your kid $6,000 to take out the trash one time just so he can max out his Roth IRA. Work with your tax professional to determine what is appropriate from a wage standpoint if you’re planning to hire your child for work.
Reasons to Open a Roth IRA for your Child
1. The Tax Advantages of Roth IRA’s Favor Long-Term Growth
With Roth IRA’s, you are delaying the tax break by contributing to the account with after-tax dollars. From there, if you take a qualified distribution from the account, the funds will not be taxed. Your future self, or should I say your child’s future self, loves Roth IRA’s.
Let’s use an example here.
Say your child can make a $6,000 investment into their Roth IRA and you let it sit for 50 years and never contribute again. Assuming a 7% average annual return by using a diversified investment portfolio, the account balance will be just over $175,000 after that 50-year span. When your child goes to make a qualified withdrawal, none of it will be taxed! Beautiful, isn’t it?
Your minor child’s annual income level will likely be in the lowest income tax bracket (unless they’re a child actor as a lead actor in big production movies). Therefore, they arguably don’t need any tax deductions now.
Being able to make an after-tax deposit now into a Roth IRA that can be accessed tax-free in the distant future when your child’s tax rate is likely a lot higher, is a fantastic thing.
2. The Earlier you Start, the Greater the Growth Potential
Every dollar counts when saving for retirement. That is especially the case when you are younger, as that allows more time for your account to grow.
If we go back to the example above, this highlights the power of compounding returns. Compounding returns is the growth you earn on both your original money and on the rate of return you continue accumulating over time. This is how that measly $6,000 contribution becomes over $175,000 with only a 7% average annual return.
Once your child begins earning taxable income, no matter how much that may be, contributing some or all those dollars into a Roth IRA can have a huge impact on their retirement.
3. Savings vs. Investing
Since Roth IRA contributions are not designed to be accessed for such a long period of time, especially if these contributions are for a minor, it will be important to make sure the account is properly invested. The main goal here is long-term growth. To receive that long-term growth potential, the account needs to be an active participant in the stock market. This will allow for the greatest possibility of strong investment returns over time.
A savings account is a great tool – in the short term. If you have any major expenses coming up in 5 years or less for your child, such as their first car, it may be smart to keep those funds in a savings account. This way the dollars aren’t exposed to a market decline when you need them. When you have longer term goals, such as retirement savings, investing can be much more attractive.
The current online high interest savings account is providing you with around 0.5% of annual return. With inflation in the U.S. historically averaging 2-3% annually, you are effectively losing money over time by using a savings account.
With a long-term investment portfolio, the goal will be to have annualized returns much higher than inflation, so we can maintain our standard of living over time. The only way to do that will be to invest in something that has the opportunity to grow over time.
What are the Roth IRA Distribution Options?
With a Roth IRA, the mindset for these funds should be retirement savings, not funds that are withdrawn before age 59.5. If you do withdraw your funds early, you are subject to taxes and penalties on the growth in the account, outside of a few specific exceptions. You are also forgoing all the potential tax-free growth in the account by pulling out your funds early.
Below are the distribution options of a Roth IRA:
- You can always access the principal (amount contributed) tax-free and without penalty.
- Withdrawals on the growth in the account are subject to regular income taxes and a 10% penalty.
- This is one you really want to avoid. You are now subject to your normal income tax bracket and a 10% penalty on these dollars, which isn’t ideal.
- Qualified Distributions (distributions without income tax or penalty):
- Made on or after the date you turn 59½
- Taken because you have a permanent disability
- Made by a beneficiary or your estate after your death
- Used to buy, build, or rebuild your first home (a $10,000-lifetime maximum applies)
- The home purchase option may be tempting, but this one should be avoided if possible due to the growth and tax advantages of leaving the funds in the account over time.
How Do I Open a Roth IRA for my Child?
To open a custodial Roth IRA, you will need to first chose an investment firm that you want to work with in opening the account. From there, you will just need to provide personal information such as social security numbers, address, etc. As for contribution limits, this will be dependent on your child’s earned income for the year.
When looking at your options in the account opening process as well as how to invest your contributions, if unsure what to do, be sure that you are reaching out to a financial professional to assist.
Start Early and Reap the Benefits
Overall, a Roth IRA can be a great way to kick off a child’s retirement savings plan through long-term tax-free growth. Start this early in their lives when they begin earning an income, as even small contributions can make a huge impact for your child down the road.
If this is something you’d be interested in implementing for your child, we would be happy to talk through you options in how to utilize this in your financial plan.
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Investing involves the risk of loss, including total loss of principal. Consult with a tax professional for tax implications for your particular circumstances.