Here at SYM, our team gets lots of questions from clients about Roth IRA for kids. In fact, we have discussed the benefits of opening a custodial Roth IRA for the next generation before and covered the pros and cons in a separate article. Still, we wanted to take an in-depth look at some of the strategies for optimizing a Roth IRA for children.
First things first. A “Roth IRA for kids” is a Roth IRA opened by an adult for the benefit of a minor. The minor must meet at least two important requirements: they must be under 18 years old, and they must have employment compensation. Employment compensation can come from a newspaper route, babysitting, or working in a family business. Before we jump into the rules and nuances, let’s cover some of the arguments in favor of opening a Roth IRA for kids.
Roth IRA for kids tax advantages: earning sand withdrawals
There are many important benefits that come with opening a Roth IRA account for kids. While the account holder does not receive a current-year tax deduction, the account grows tax-free forever (so long as distributions meet the requirements). Earnings in the account are eligible to be withdrawn without federal taxes or a penalty when the account owner hits age 59½.
There is one other feature of a Roth IRA for kids that is important. Withdrawals from the account come out of contributions first, which are generally tax-free. Let’s say that your child reaches the age of 30 and wishes to withdraw some funds from the Roth IRA to pay for a wedding or make a down payment on a house. Any contributions made to the account can be withdrawn at any time, for any reason.
Roth IRA for kids account features
Just about anyone with income can open a Roth IRA. As it pertains to opening a Roth IRA for a child, we mentioned a few eligibility rules at the onset. Since this is a custodial account, the adult (usually a parent) maintains control of the account until the child reaches the age of majority, which is 18 or 21 depending on your state of residence. The Roth IRA must be for the minor’s sole benefit while statements may continue to go to the adult.
The most you can contribute to the Roth is the child’s earnings up to $6,000 as of 2021. There is typically no minimum investment required. Investment options are vast — stocks, bonds, ETFs, mutual funds, and many other assets can be housed in a Roth IRA. SYM Financial Advisors is here to help you plan for your children’s future and make investment recommendations.
Benefits of the Roth IRA for kids
Albert Einstein is known to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
A Roth IRA for kids is perhaps the greatest tool available to take advantage of compounding returns. It’s all about having more time in the market. Consider that a 6% annual return doubles the originally invested amount about every 12 years (using the rule of 72). So, $1,000 invested for a teenager today could grow to nearly $20,000 by the time he or she retires, all growth being tax-free since it is within a Roth IRA. The benefits of more time in the stock market with tax-free growth make a Roth IRA for kids a valuable gift to bestow on your loved ones. We have talked about it in our podcast, too. In general, strategic gifting within one’s family is much more lucrative than a few tinker toys!
Two types of IRAs for kids
There are two types of IRAs: Traditional and Roth. A traditional IRA’s main benefit is the up-front tax break that the account holder receives when he or she contributes. For kids, a Traditional IRA will very rarely make sense because, being in a very low tax bracket, the child will not be able to take much advantage of the tax deductibility of a contribution. A Roth IRA is best for individuals in their low-earning years because the account holder is essentially paying taxes today (presumably in a lower tax bracket) and avoiding taxes in the future.
Roth IRA is a popular choice for kids since it is unusual for a child to earn a high enough income to push them into a higher tax bracket. So, it may be beneficial to pay tax today (which is often at the 0% tax rate — the best rate around!) and avoid tax later.
Can you open a Roth IRA for a child?
Yes! Any adult can open a Roth IRA for a child who has earned income as defined by the IRS. It is a simple process of opening a custodial Roth IRA, then making cash contributions from the adult. A Roth IRA is often used as a gifting strategy, which could be more effective than simply giving the child a plain US Savings Bond on birthdays or during the holidays. As we demonstrated above, the return potential is significant. A small contribution today can go a long way toward the child’s retirement. A custodial account, also known as a guardian account, is also an opportunity to talk with the youngster about the benefits of saving and planning for the future.
When can you open a Roth IRA for your child?
You can open a Roth IRA for your child at any time, but contributions can only come in years when your son or daughter has earned income. Some entrepreneurs even employ their young kids to take advantage of this strategy. While it is important for the child to have earned income in order to qualify for Roth IRA contributions, the child does not have to be the one to make the contribution. In other words, parents can make the contribution on the child’s behalf — as long as the scenario meets the requirements. Be mindful of the April 15 tax deadline to make prior-year contributions.
Can you use a Roth IRA to pay for the child’s college?
A Roth IRA can be used to help pay for the rising costs of college. We have written on the benefits of 529 plans in the past, but many people are surprised to hear that a Roth IRA can be a possible vehicle for education savings, too. While a Roth IRA for kids is not designed to be used strictly for college expenses, it can certainly offer an opportunity to tap the account when the need arises(since contributions can be withdrawn at any time, tax-free and penalty-free).
How to fund a child’s IRA
A common strategy is that the child earns money at a job (not investment income) and uses that money to pay for everyday expenses. The parent then takes her or his cash and simply contributes to the custodial Roth IRA in an amount up to the child’s earnings. In today’s investment world, there is often no minimum investment to meet. It’s up to the parent to choose an investment within the Roth IRA, and SYM Financial Advisors is here to help in that process.
If a child struggles to save their own earned income (a weekly allowance does not qualify as earned income), a parent can also gift the funds to the child (with limits) to contribute to a Roth IRA.
Can others contribute to a Roth IRA for kids?
While other individuals can contribute to a Roth IRA for kids, gift tax rules must be top of mind. On the SYM Insights blog, we go in-depth on Gifting Within Your Family. There are important rules to follow.
As individuals, we are only allowed to gift so much during our lives due to the lifetime estate exclusion. For 2021, that limit is $11,700,000 for an individual or $23,400,000 for a married couple. As a general rule, any gift is a taxable gift and included as part of your lifetime exclusion unless it qualifies under one of the following exceptions:
- Gifts that do not exceed the annual limit for the calendar year ($15,000 in 2021 to each recipient). A husband and wife pair can gift a total of $30,000 each year to a single individual through what is commonly referred to as “gift splitting.”
- Tuition or medical expenses you pay for someone, as long as the education or medical costs are paid directly to the institution.
- Gifts to your spouse.
- Gifts to a political organization for its exclusive use.
Roth IRA for kids: more than just building a nest egg
The benefits of a Roth IRA for kids go beyond just building an IRA balance. It’s a wonderful opportunity to talk with your children about financial literacy. Parents have an opportunity to teach kids the basics of money since it is hardly touched upon in a typical classroom. You don’t have to provide an investment summary to your child each month, but you may want to use this as a chance to discuss saving, investing, and being financially responsible.
Another benefit we touched on earlier is that the child can withdraw contributions from the IRA account tax and penalty-free to pay for college. Roth IRA earnings can also be withdrawn to pay for qualified higher education expenses penalty-free, but this withdrawal may trigger income taxes. A family should weigh the pros and cons of a student taking on debt (and paying interest) versus withdrawing funds from an IRA and potentially paying taxes. If the interest rate on student loans is low enough, it could be financially advantageous for the child to leave the Roth IRA untapped.
Roth IRAs have other benefits, too. After the account has been funded for five years, up to $10,000 of earnings can be taken out to purchase a first home tax-free and penalty-free (that includes down payment and closing costs). It is important to note that this feature is specific to earnings since contributions can be withdrawn at any time. In this manner, a Roth IRA can be a lifeline for young individuals and couples looking to put down roots in a neighborhood.
A Roth IRA can be used as an excellent emergency fund account, as well. The rule of thumb for most people is that it is prudent to have saved about three to six months’ worth of cash in the event of a financial emergency, such as an unexpected bill or a job loss. Since Roth IRA withdrawals begin with contributions, you can sell investments in the Roth, then withdraw an amount up to your total contribution amount in an emergency. While this is not an ideal scenario, the Roth IRA provides a last-ditch cushion when you need the funds.
The Roth IRA has many benefits, but the best of them is seeing your account grow. In order to take advantage of compounding growth, it is best to avoid tapping the account until you retire.
Investing at a young age
In conclusion, opening and funding a Roth IRA for your kids is a tremendous gift and a powerful tool to build generational wealth within a family. Compounding returns and growth from adolescence to retirement is tough to beat. The tax treatment is also favorable, considering that the child is likely to be in a low tax bracket when contributions are made. Finally, the opportunity to develop healthy financial habits early in life could be as valuable as the account itself.
A Roth IRA for kids is a powerful strategy to consider. Sit down with us at SYM Financial Advisors to talk about how we can help you and your family. We offer guidance on the best retirement saving strategies and comprehensive financial planning services.