Of all the ways to teach your kids about money and help set them up for the future, a custodial Roth IRA may just be the best.
With a custodial Roth IRA, you can encourage your child to earn money, show them the power of saving and investing, and jump-start their retirement savings with a tidy stack of tax-free cash. There are a few rules to navigate, but it’s easier than you might expect, and the rewards can be well worth it.
What is a custodial Roth IRA?
A custodial Roth IRA is simply a Roth IRA set up for a minor child. The tax treatment is the same as a regular Roth IRA since you make contributions with after-tax money. Withdrawals are also tax-free as long as they meet the qualified distribution criteria, which typically means that the account has been open for at least five years and the account owner has reached age 59 ½.
Since minors can’t open brokerage accounts themselves, an adult acts as the custodian in charge of handling investments and making contributions and withdrawals with a custodial Roth IRA. Then, when the child reaches adulthood (age 18 to 25, depending on the state), the custodian transfers the account to the child (now a legal adult), who owns it outright.
The biggest catch with a custodial Roth IRA is that your child has to have earned income to be eligible for contributions. However, many types of income qualify, from a regular job and babysitting to mowing lawns and helping with your family business.
“Even if they're only making $1,000, they can still contribute up to $1,000 into a Roth IRA,” says Matt Fizell, a certified financial planner and Owner of Harmony Wealth in Madison, WI. Annual
How a Roth IRA for kids can put yours ahead
While a Roth IRA for kids might seem like overkill, the tax breaks alone are almost perfectly designed to benefit a child who wants to start saving for their future. Because their income is likely low, they won’t miss the tax deduction that often comes with traditional IRA contributions. They’ll also benefit from a head start of nearly a decade (or more) on their retirement savings. The longer their money has to grow, the better.
“Say your child is 15 and potentially retiring at the age of 65,” says Ryan Langan, CFP, founder and lead financial planner at Your Path Fi in Philadelphia, PA. “We're looking at 50-plus years of growth inside this Roth IRA, all tax-free. Let's say they have a summer job, earn a couple of grand and put it into a Roth IRA, do the same thing next summer and, maybe the summer after. Potentially, they could have hundreds of thousands of dollars by the time they reach age 65.”
For example, let’s say your child invests $1,000 at age 15 and earns a 7% return compounded annually—a reasonable return rate based on the stock market's historical performance. By age 65, that single $1,000 will grow to $29,457, with no additional contributions.
If your child can invest the maximum of $6,500 at age 15 and earn that same 7% annual return, it will grow to $191,471 by age 65. Using the 4% safe withdrawal rule, that’s an annual retirement income of $7,659 that they’ll have from just a single contribution.
Another significant benefit of a custodial Roth IRA is teaching your child about money. First, they have to earn money to be eligible to contribute. Then, they can experience firsthand the power of saving money and keeping it invested for the long term.
“The biggest thing is you're teaching them the right lessons about letting that money compound over time,” says Fizell. “And it may take some of that pressure off of them needing to save more when they're first out of college, in those early years of their career, when they may not be making as much money as they will someday.”
Custodial Roth IRA rules
The idea of opening and managing a custodial Roth IRA may sound intimidating, but for the most part, it’s pretty straightforward. You just have a few rules you’ll need to mind regarding contributions, limits, taxes, and transferring ownership when the time comes.
Who can contribute
While your child must have earned income to be eligible for contributions, those contributions can come from anywhere—the child, their parents, grandparents, or anyone else.
This opens up some exciting opportunities, but Langan says it can be challenging to encourage a child to part with their hard-earned cash. In those cases, some extra motivation might be in order. For example, you might encourage your child to contribute by offering to match their contributions, just like your employer might do with your 401(k). Your child could also use other money they’ve received—like birthdays or an allowance—to make contributions instead of using money earned from their job.
Annual contribution limits
Custodial Roth IRAs are subject to the same contribution limits as regular IRAs. For 2023, those under age 50 can contribute up to the lesser of $6,500 or your earned income for the year.
For example, if your child earns $10,000, they can contribute up to $6,500. If they only earn $3,000, then their maximum contribution would be $3,000.
How taxes work with custodial Roth IRAs
The tax treatment of a custodial Roth IRA is the same as a regular Roth IRA.
Contributions aren’t tax-deductible, but their money grows tax-free, and they can withdraw it tax-free so long as the withdrawal meets the qualifying criteria. To count as a qualified distribution, the account must have been opened for at least five years, and the withdrawal must be made after the account holder reaches age 59 ½, is disabled, has died, or is making a first-time home purchase (up to a $10,000 lifetime limit).
One significant benefit of all Roth IRAs is that you can withdraw contributions tax and penalty-free at any time and for any reason. However, any earnings you withdraw early are subject to taxes and a 10% penalty (with some exceptions).
Transferring ownership when your kid reaches 18
Once your child reaches legal adulthood in their state of residence, you must transfer the Roth IRA into their name and remove yourself as custodian. At that point, the child (now an adult) will fully control the account.
The exact transfer process will vary by custodian, but it’s generally straightforward. You’ll need to open a new Roth IRA in your child’s name. Then, your custodian can walk you through transferring the assets in the custodial Roth IRA into the new, non-custodial version your child owns.
Making withdrawals from a custodial IRA
One key point to remember is that money within a custodial Roth IRA must be used for the child's benefit, regardless of where it came from. That means that even if you contributed your own money, you can’t change your mind and use it for yourself.
However, you can potentially make early withdrawals for things like school tuition or even a car for your child. Roth IRAs allow you to withdraw up to the amount you’ve contributed at any time and for any reason, so you have some flexibility to access that money before your child reaches 18. However, earnings should usually remain in the account as early withdrawals are taxed and subject to a 10% penalty.
Roth IRAs for kids: the pros and cons
Custodial Roth IRAs offer some notable benefits but aren’t the best option for every situation.
Pros
- Low current tax rate. Your child is likely in a low tax bracket today, possibly even the 0% bracket, making the lack of a tax deduction for contributions immaterial.
- Tax-free withdrawals. Regardless of their future tax bracket, your child can withdraw their Roth IRA savings tax-free in retirement.
- Decades of growth. Starting early means your child gets the benefit of decades of compound returns.
- Teach your kids about money. From earning to saving to investing, custodial Roth IRAs are a great way to teach your children basic money principles.
Cons
- Earned income requirement. You can only contribute if your child has earned income, and only up to the amount they earned.
- Qualified withdrawal criteria. Earnings will be taxed and penalized if withdrawn without meeting the qualified withdrawal criteria.
- Must be used for the child. All withdrawals must be used for your child’s benefit, even if you contribute your own money.
- Loss of control. The money becomes your child’s once they reach legal age, whether or not they are ready to handle that responsibility.
How to open a custodial Roth IRA
Opening a custodial Roth IRA is typically a simple process that you can complete online in 10-20 minutes. You will just need personal information for both the child and the custodian, such as names, birth dates, and Social Security numbers.
The hardest part may be finding a provider. Not all Roth IRA providers offer custodial Roth IRAs, though many major ones do, including Charles Schwab and Fidelity.
The takeaway
If your child has earned income, a custodial Roth IRA can be a powerful way to teach them some essential money principles and jump-start their financial future with the potential for decades of tax-free growth. When mindful of the contribution, withdrawal, and account transfer rules, this account can be a win-win for you and your child for years to come.
