Opening a Roth IRA for your child can be a huge headstart
- You can open a Roth IRA in a kid’s name to help him or her save for retirement, a first house, or, subject to some rules, educational expenses.
- Children must have earned income in order to have a Roth IRA in their names.
- The kids generally won’t owe taxes on the money when they withdraw it, no matter how much they have earned in the account over the years.
Many people ask, “Can I open a Roth IRA for my kid?” The answer is broadly, “Yes” and it’s getting easier. A handful of brokerages, including Fidelity and Schwab, now offer Roth IRAs for kids. Adults, usually a parent or grandparent, control them, but the account is opened in a child’s name. When she becomes an adult, she assumes control of the account. It seems a long time off, but it can give your child a great start on retirement accounts and teach them the value of saving. In addition, under certain circumstances, you can use the money to buy a house, or to fund educational expenses, or in an emergency.
The bonus: If you open a Roth IRA for a child, the money has a longer time to grow, or compounding. That can make a big difference. For example, if you make a single, one-time contribution to a child’s Roth IRA when they are 15, that will turn into more than $160,000 tax free when they are 65 (assuming a 7% annual return). If they waited until they were 35 to contribute to a Roth, they would need to save $22,000 to reach that same amount.
In this article, we’ll cover:
- Eligibility rules for Roth IRAs for children
- How to open an account and which brokerages offer them
- Investing in the account
- What the money can be used for
- How to use the accounts to teach your kid about money
The most important thing to know about opening a Roth IRA for a child is that he must have earned money during that tax year. You (or he) can contribute as much as he made, up to the annual Roth IRA limit (currently $5,500). The same rules that decide eligibility for Roth IRAs apply to the account you open for your child. You or another adult will be the custodian on the account, but he or she will be the owner.
It’s up to you (or the child) to document that she had income earned from work. The money can’t be an allowance or a gift. (You can find more about the IRS’s definition here). It’s up to the account custodian to document the service rendered, when it was done, and the payment. It also has to be a reasonable rate. You can’t pay $1,000 for a night of babysitting.
But, the contribution you make to your kid’s Roth IRA can be a gift from you or someone else. Remember to consider the IRS’s gift tax rules. The contributions you make to a Roth IRA for your kid will count against the limit on tax-free gifts you can make to one person, currently $14,000, for the year.
You can open a custodial IRA at many brokerages. Fidelity has begun marketing a Roth IRA for Kids that includes supporting marketing material to help guide you. Look for a $0 fee on the account, and a low or $0 account minimum. You will probably have a small fee of less than $10 for each trade, and should aim to keep the number of trades as small as possible.
Fidelity’s account has no minimum. “We saw a real uptick in requests for this two-three years ago,” said John Boroff, director retirement product management at Boston-based Fidelity Investments. “I think it could be uncertainty around the future of Social Security … and more awareness of Roth IRAs.”
In a custodial Roth IRA, or a Roth IRA for Kids, the adult controlling the account is the only person who can make investment decisions. There are three ways to approach investing in a Roth IRA:
- Design the portfolio yourself
- Buy a target-date or lifecycle fund that automatically adjusts as your child grows
- Consult a financial advisor, one who works at your brokerage or an independent one
If you begin your kid’s Roth IRA with a small amount, like $500, you may need to wait to buy certain funds. Some mutual funds have a $2,500 minimum, said John Boroff, director retirement product management at Boston-based Fidelity Investments.
Remember, the big benefit of a Roth IRA is that whatever money you earn from your investments won’t be taxed when you withdraw it. That benefit is subject to one restriction, however: The money must be held in the account for at least five years to get the full tax benefit.
After the childe who owns the account is 18 (or 21 in some states), you can take steps with your brokerage to shift the account into his or her control. As long as the account has been open for five years, he or she will have options for how to use the money.
- For retirement savings. The owner (the child who has grown up!) can withdraw the money after 59 1/2. No taxes will be owed on the earnings.
- To buy a house. The owner can withdraw funds to buy a house before reaching 59 1/2. The money must be used as a down payment for closing costs. The withdrawal is limited to $10,000. Early withdrawals for a home purchases are penalty and tax-free.
- For education expenses. The owner can withdraw money for college, but she will pay taxes on the earnings. However, there is no 10% early withdrawal penalty if the money is used for qualified education expenses (tuition, feeds, books, supplies equipment and most room and board charges).
- For emergencies. The owner of a Roth IRA can withdraw money in an emergency. But the withdrawal will be subject to taxes on the earnings, plus a 10% early withdrawal fee.
How To Use A Roth IRA To Teach Kids About Money
It’s hard for some kids to save money that they have earned, when they would rather be spending it on games, movies or clothes. Some parents make contributions to their daughter’s Roth IRA as a reward or match for the money earned in a summer job or over the year, said Boroff. A Roth IRA For Kids offers a chance to reinforce the value of earning money, and show kids that you value saving for the future. “It’s really about teaching them about saving for the long-haul,” Boroff said.