Why You Should Open a Roth IRA for Your Child

(DC Studio/Shutterstock)

You can give your child a head start in life by opening an individual retirement account (IRA) for them. Allowing it to build interest for decades enables it to grow much more than if you wait until the child is older. Custodial Roth IRAs have some rules that must be followed, but it has many benefits that will make it worthwhile.

Custodial Roth IRAs, like regular Roth IRAs, are designed to save money for retirement. The interest grows tax-free, and all legitimate withdrawals are also tax-free. They do not provide any tax deductions because the contributions use after-tax money.

The Basic Requirements

There are two basic requirements for opening a custodial Roth IRA for minors. The first rule is that the child must have their own taxable income. TheBalanceMoney says that the Internal Revenue Service (IRS) defines taxable income as wages, commissions, salaries, bonuses, tips, or self-employment income. The child’s income needs to be reported on tax forms.

The second requirement is that contributions are limited to the amount of money the child has for income. They could also contribute up to the IRS contribution limit if they make that much money, which is $6,500 for 2023.

Forbes says that it is not necessary to prove that the money comes from the child’s income, which would allow the child to save the money and you make the contribution. You only must prove that the child has their own income.

Other people can also make contributions if they wish to do so. The contribution limits are still in place.

The Required Oversight

Because you are opening the Roth IRA for a minor, the primary custodial parent will make the investment choices for the child. You can choose from many different types of assets, including stocks, bonds, cash, and alternative investments.

Over time, the parent can train the child to make good investment selections to enable the account to grow faster. Wrong choices can cause a loss of investment money, but diversification can help prevent it in the long term. They can also help the child to decide how much to contribute. Parents, Bankrate suggests, can even choose to “match” contributions.

The parent retains oversight of the account until the child reaches the age of adulthood, which will vary by the state where you live. It could be anywhere from age 18–21. At that time, the child gains complete control over the money in the account.

A New Rule About 529 Plans

When the Secure Act 2.0 was passed, it included an option that enables transfers of a maximum of $35,000 from a 529 College Savings Plan without taxes to a custodial Roth IRA. Transfers have to go to an account in the same person’s name, and the child still must have their own income. The contribution limits are also still in place.

Advantages of a Custodial IRA

Roth IRAs and custodial Roth IRAs are one of the best tools for money to grow. Interest rates are usually much higher than you would have with a standard savings account.

The rules on withdrawals are not as strict as they are with a non-custodial Roth IRA. A custodial IRA lets you withdraw the contribution money at any time without a penalty. NerdWallet says that all earnings on the contributions will have penalties when withdrawn—and they will be taxed as income and may incur a 10 percent penalty.

Later on, Fidelity says, withdrawals can be made of up to $10,000 before reaching 59½. The money must be for first-time home buyers, and the five-year rule must be met.

Possible Withdrawals Without Penalties

There are always things that a child may need as they get older. A custodial Roth IRA enables children to withdraw some money for various purposes without any penalties. The primary purpose of a Roth IRA is to save money for retirement. Fidelity says there is a five-year rule, which states that the account must have been open for five years before making any withdrawals or penalties will be applied.

After that time, withdrawals can be made on the contributions. They can be made for college expenses, medical costs, buying a car or a house, emergencies, etc.

During retirement, withdrawals from a Roth IRA account are tax-free. Withdrawals made from a traditional IRA are taxed, based on the person’s income. A Roth IRA does not have any minimum required distributions, so the money can continue to grow after retiring.

Roth IRA vs. a Traditional IRA

When you open a custodial IRA for your child, you can open a Roth IRA or a traditional IRA for them. Each one has its advantages.

A Roth IRA does not give any tax breaks upfront because contributions are made with aftertax dollars. Because there are no taxes on withdrawals, this kind of IRA can be ideal for a beneficiary who will probably be in a higher tax bracket during their retirement years.

A traditional IRA gives immediate tax deductions with contributions. The contributions are made pretax, which means that taxes will have to be paid on withdrawals. This form of IRA is ideal for people who expect to make less money during retirement than during their working years.

Starting a Roth IRA for a minor is an excellent idea because it gives many years for the interest to grow. Letting your child see the growth can encourage them to save. Setting up a Roth IRA does not take long—often about 15 minutes. You will need an ID and Social Security number and the child must prove taxable income.

The Epoch Times Copyright © 2023 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.