Opening Roth IRAs for your kids can give them a huge head start

Quick Summary

  • A Roth IRA can help your child (or grandchild) save for retirement, a first home, or educational expenses.
  • Kids are poised to take full advantage of time, and the power of compounding. 
  • Even small contributions now can grow into a sizable nest egg later.
  • Any child, regardless of age, can contribute to a Roth IRA provided they have earned income.

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 Vanguard, 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 the child becomes an adult, he or she assumes control of the account. 

It seems a long time off, but an IRA can give your child a great start on retirement accounts and teach the value of saving. In addition, under certain circumstances, the money can be used to buy a house or fund educational expenses.

The bonus: If you open a Roth IRA for a child, the money has a longer time to grow, benefiting from compound interest. That can make a big difference. 

If you make a single, one-time $6,000 contribution to a child’s Roth IRA when they are 15, for example, that can grow to more than $176,000 of tax-free money by the time they hit 65, assuming a 7% annual return. If they waited until they were 35 to make that first contribution, they would need to invest $23,000 to reach the same amount.

Eligibility Rules for Kids’ IRAs

The most important thing to know about opening a Roth IRA for a child is that they must have earned income during that tax year. You (or the child) can contribute as much as they made, up to the annual Roth IRA limit (currently $6,000 in 2019). 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 the child will be the owner.

It’s up to you (or the child) to document that they had earned income from work. It’s a good idea to keep receipts or records that include:

  • The type of work
  • When the work was done
  • Who the work was for
  • How much your child earned

The money can’t be an allowance (even if the child does chores for it) or a cash gift given directly to the child. (You can find more about the IRS’ definition here.) Of course, it also has to be a reasonable rate. You can’t pay $1,000 for a night of babysitting.

Contributions to a child’s Roth IRA can be a gift from you or someone else. The IRS doesn’t care who contributes the money as long as it doesn’t exceed the child’s earned income for the year. Keep in mind that since the contribution is made to your child’s IRA, your child (and not you) receives any tax deduction. 

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, which is $15,000 for 2019.

How to Open a Kid’s IRA

While it may sound a little strange, there is no minimum age that a person must be in order to own a Roth IRA.  But of course, there are state and federal laws regarding minors and financial accounts in general. That means a parent or other adult has to open a custodial Roth IRA for a child. Not all brokerages offer custodial Roth IRAs, but several do, including Fidelity, Vanguard and Charles Schwab. 

In a custodial Roth IRA, the adult who controls 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, either one who works at your brokerage or an independent one.

If you start your kid’s Roth IRA with a small amount, like $500, you may need to wait to buy certain funds. Some mutual funds, for example, have a $2,500 minimum investment. 

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.

What the Money Can Be Used For

After the child who owns the account is 18 (or 21 in some states), your brokerage can help you shift control of the account. 

As long as the account has been open for five years, there are several options for how to use the money.

  • For retirement savings. The owner (the child who has grown up!) can withdraw the money after age 59½. No taxes will be owed on the earnings.
  • To buy a house. The owner can withdraw funds to buy a house before reaching 59½. The money must be used as a down payment for closing costs. The withdrawal is limited to $10,000. Early withdrawals for a home purchase are penalty-free and tax-free.
  • For education expenses. The owner can withdraw money for college, but they will pay taxes on the earnings. However, there is no 10% early withdrawal penalty if the money is used for qualified education expenses (tuition, fees, 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

A Roth IRA for kids offers a chance to reinforce the value of earning money and to show kids that you value saving for the future. Many financial experts and educators think the earlier kids learn about money, the better their chances for financial stability in the future. 

It’s hard for some kids to save money they earn when they would rather be spending it on games, movies, or clothes. Some parents make contributions to their child’s Roth IRA as a reward or match for the money earned in a summer job or over the year. Either way, starting a Roth IRA early can make a big difference to your child’s financial security later on.

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