Most investors are familiar with the standard mechanisms of the Roth IRA: A person contributes post-tax money to a retirement account, typically for him/herself, and those funds experience tax-free potential growth as long as they are not withdrawn until the person reaches the age of 59 ½.
In most families this is the primary and often sole use of the Roth IRA. However, the Roth IRA can also be an effective financial conduit for parents and grandparents as a custodial Roth IRA. This second and less familiar function of the Roth IRA gives parents and grandparents a new vehicle with which to disperse their own wealth – and instill their values and work ethic in the next generation. When used properly, a custodial Roth IRA can teach children the value of compound interest and the basics of filing a tax return, while also offering a head start on retirement savings.
Taking advantage of this strategy requires the child to have earned income equal to or greater than the amount of the contribution. That means the first step is encouraging the children or grandchildren to earn some money for themselves. Expect documentation to be required at tax time, which means the child also gains the life experience of filing what may be his or her first tax return.
After the grandkids take the initiative to clear the income hurdle, a parent or grandparent can begin to contribute to the Roth IRA on the child’s behalf. One approach may be for Nana to offer a matching contribution on a percentage of the grandchild’s earnings, depositing that amount into the child’s Roth IRA each pay period. Because parents or grandparents are able to make deposits for the purpose of savings and the child can still spend the money he or she earned (contributions to the Roth IRA don’t have to be the child’s own money, but cannot exceed their income), the “Kid Roth” can become an appealing incentive for a child to find employment.
Custodial Roth IRA contributions are limited to the amount of the child’s annual income. However, suppose Nana contributes to a Roth IRA set up in the name of her 14-year old granddaughter who earns $2500 each year in babysitting and yard work. In this example, as long as the granddaughter continues to earn $2500 in annual income, Nana can deposit up to $2500 to the Roth IRA for her every year.
For the next five years, Nana continues to match her granddaughter’s income with Roth IRA contributions. By the time her granddaughter turns 19, Nana would have invested a total of $12,500. Custodial Roth IRAs offer the same benefits a traditional Roth IRA: the potential for tax-free growth and the opportunity to earn compound interest. The key to compounding is time, and Nana’s granddaughter may already have a good start on saving for retirement even if she never made another deposit into this account.
Let’s contrast this child’s scenario with someone who followed a more typical timeline for opening a Roth IRA investment account. A different girl, who at 14 did not have the gift of a custodial Roth IRA but instead began saving to one at the age of 35 after her career had taken off and she felt she had a comfortable amount of discretionary income. For the next 25 years, she annually set aside $5000 toward the Roth IRA. By the time she turned 60, she’d deposited a total of $125,000.
Assuming identical net rate of return, by age 60 the account balances in both girls’ respective Roth IRAs may be very similar. However, they took very different paths to arrive at that place. To achieve the same account balance at retirement, the second woman had tosave for 25 years vs. the first woman’s five. She also contributed ten times the amount of money: $125,000 compared to the first woman’s $12,500 (deposited by her grandmother when the first woman was just a teenager).
The benefits may not end there. After all, Nana’s granddaughter’s account balance is based on just five years of deposits which ended when she turned 19. Given the lessons learned from a forward-thinking and generous grandma, this young lady is likely to continue to make Roth contributions on her own after age 19. For the rest of her working career, she can deposit up to the current Roth IRA maximum of $5500 per year, and watch her Roth balance grow even more.
There are many reasons to view the custodial Roth IRA as a powerful tool for parents or grandparents, not the least of which are the invaluable lessons on long-term investing. In addition to getting a head start on retirement savings, these kids learn firsthand how hard work results in lifelong rewards.
Kid Roth Tips to Remember:
- The child must have earned income in order to qualify for a Roth IRA contribution. Gifts and earnings from investments and savings do not qualify.
- The child and custodian must document the income. Consult with your CPA, but this usually means compiling records and filing a tax return.
- Once the custodian (i.e. grandparent or parent) makes a contribution for the child, they cannot take it back.
- The principal can be withdrawn tax and penalty-free at any time by the Roth IRA owner (i.e. the child). Any withdrawals must be for the exclusive benefit of the child.
For questions on the Kid Roth or any other investment, savings or wealth transfer strategy, call your SYM advisor.
Disclosure: SYM Financial Corporation (“SYM”) is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about SYM, including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.