What is a Custodial Roth IRA and Should I Open One for my Child?
A Custodial Roth IRA is a type of Roth IRA that a parent or guardian opens on behalf of a minor. This account is an excellent way to jumpstart your child’s retirement savings, offering them the advantage of tax-free growth over many years. By starting this account early, you’re not only helping them build a solid financial foundation but also instilling the importance of saving and investing from a young age.
What is a Custodial Roth IRA?
A Custodial Roth IRA allows a parent to open and manage a Roth IRA for a minor. The account is owned by the child, but the parent or guardian manages it until the child reaches the age of majority, typically 18 or 21, depending on the state. This account type is particularly beneficial for children who have earned income but may not have the knowledge or ability to manage their retirement savings yet.
Earned Income Requirement:
To contribute to a Custodial Roth IRA, your child must have earned income. This can come from traditional W-2 income sources, such as an after-school or summer job, or from self-employment, like babysitting or freelance work. The income must be verifiable, as this is a key requirement for opening and contributing to the account. There is no age requirement for opening a custodial Roth IRA so long as the child has earned income.
TIP: While there is an earned income requirement there is also an effective strategy where the parent can “gift” the child the full or partial amount of the contribution. This approach allows the child to enjoy their earnings while still contributing to their Roth IRA. For instance, if your child earns $3,000 from a babysitting job, you as the parent could contribute $3,000 on their behalf since they had $3000 in earned income and still allow the child to keep the earnings for them to use/spend. You could also consider contributing half of the earned income they had for the year ($1500) and then the child contributing the other $1500 while still allowing them to keep some of their hard earned money to spend while still making the child have some “skin in the game” so to speak.
Contribution Limits:
The contribution limit for a Custodial Roth IRA is the lesser of your child’s earned income or $7,000 per year (as of 2024). For example, if your child earns $5,000 in a year, that is the maximum amount they can contribute for that tax year. If they earn $8,000, they would still be limited to the $7,000 cap.
Time Advantage:
Starting a Custodial Roth IRA for your child maximizes the time their investments have to grow through compound interest. While any individual can open a Roth IRA at age 18, opening one even earlier enhances the time value of money and helps establish a habit of regular contributions. This early start not only amplifies the growth potential of their savings but also ingrains the discipline of consistent investing.
Withdrawal Rules:
The same rules that apply to a regular Roth IRA apply here. Contributions can be withdrawn at any time without penalty. However, withdrawing earnings before age 59½ may incur taxes and a 10% penalty, with certain exceptions such as first-time home purchases or education expenses. Importantly, the 5-year clock for tax-free withdrawals starts when the account is opened. This means that starting early allows the clock to start ticking sooner, making it possible to access funds for major life events like buying a house or paying for education with fewer penalties.
Long-Term Growth Potential:
Consistent contributions to a Custodial Roth IRA can result in substantial long-term growth. For example, if your child contributes $6,000 annually starting at age 10, they could potentially see their account grow to over a million dollars by retirement, thanks to the power of compound interest. Starting early not only increases the account’s value but also teaches the child the importance of regular saving and investing.
By opening a Custodial Roth IRA, you provide your child with a powerful financial tool and teach them the value of long-term planning. This early exposure to saving and investing sets the stage for a secure and prosperous adulthood.
A Custodial Roth IRA can be opened at most brokerage firms online—Vanguard, Fidelity, Schwab, etc. If you have questions about how to open and invest in a Custodial Roth IRA for your child, reach out to us, and we’d be happy to help guide you in setting your child up for success.
