Custodial Roth IRAs: What You Need To Know
Beginning to save for retirement early on makes a big difference in financial security later in life. Read on to learn how custodial Roth IRAs can teach young people important money skills, helping them grow their savings and get ready for a financially stable future.
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What Is a Custodial Roth IRA?
A custodial Roth IRA is an individual retirement account designed for minors. The account belongs to the minor, but an adult opens and manages the account until they reach a specific age. In most cases, they take over control of the account when they turn 18 — although a handful of states have set 21 as the age of majority. Until then, the minor is listed as the beneficiary of the account and can contribute to it.
The IRS has not established a minimum age requirement to open a Roth IRA, but the minor does need to have earned income. This income can come from a part-time job or work in a family business. A 16-year-old working at a fast food restaurant, a 13-year-old who babysits in the neighborhood, a 10-year-old who walks dogs and a four-month-old who appears in commercials all earn income that makes them eligible to have a custodial Roth IRA.
Custodial Roth IRA vs. Custodial IRA
Like a custodial Roth IRA, a custodial IRA is owned by a minor but opened and managed by an adult until the child is legally able to take over responsibility for the account. The primary difference between these two accounts is when the contributions are taxed.
Money placed in a Roth IRA has already been taxed, and contributions to a traditional IRA have not been taxed — and taxes will be due later. When it’s time to start withdrawing money from the account, funds from the Roth IRA are tax-free — you won’t pay income tax or capital gains tax. This gives the Roth IRA an advantage for minors who most likely are in a lower tax bracket now than they will be as retired adults.
Custodial Roth IRA vs. 529 Plan
A 529 plan — also known as a qualified tuition plan — is a state-level tax-advantaged account designed to pay for education expenses. Some 529 plans are prepaid tuition plans that let parents lock in today’s college rates and potentially save money. Others are education savings plans that are invested in mutual funds or exchange-traded funds to grow over time.
These plans have a key feature that makes them attractive. You don’t pay income tax on the withdrawals as long as you use them to pay for qualified education expenses. Several states also allow parents to use contributions to these plans as a tax write-off, and they come with additional tax advantages like higher contribution limits and no earned income cap.
Although a custodial Roth IRA is intended to be used as a retirement savings vehicle, you can tap into the account to pay for education expenses — like a 529 plan. Still, it has additional features that make it more attractive for some investors. For example, the Roth IRA owner has the option to withdraw funds to buy their first home or wait to use the money for retirement — a 529 plan must be rolled over to a Roth IRA for this purpose. Roth IRAs tend to have more investment options compared to a 529 plan, such as stocks and bonds.
Who Is Eligible To Open a Custodial Roth IRA?
Anyone can open a custodial Roth IRA for a minor. This includes parents, grandparents, extended family members and friends of the family. All they need is the child’s full legal name, their date of birth, Social Security number and mailing address.
What Are the Benefits of Opening a Custodial Roth IRA?
A custodial Roth IRA offers a minor several important benefits, starting with the ability to build savings tax-free. Since the contributions to the Roth IRA have already been taxed, they don’t have to pay tax again when they withdraw it in the future — as long as they’ve had the account open for at least five years.
Saving money on taxes is just the beginning. They can use funds in the account to make a down payment on their first home or pay for college expenses. The account also becomes a real-world example of the power of compounding, as parents and children can monitor how the balance grows over time. This can help children and teens learn the value of work and saving money for the future. Even better, anyone can contribute to the custodial Roth IRA.
What Happens if You Withdraw Money Early?
Since the contributions to the Roth IRA have already been taxed, you don’t pay tax on qualified distributions. Qualified distributions include withdrawals made after the owner turns 59 1/2 or becomes disabled, funds used to buy a first home and distributions made to the owner’s estate. Other exceptions include receiving a diagnosis of a terminal illness, paying for qualified higher education expenses, covering the cost of medical insurance premiums during unemployment and using funds to pay for birth or adoption costs. Withdrawals made for any other reason are subject to a 10% tax.
How To Open a Custodial Roth IRA
To open a custodial Roth IRA, you need to contact a brokerage firm. The representative will ask for information like the name and Social Security number of the minor. After opening the account, you can decide how much to contribute to it when the minor gets paid and how much you or other relatives will match their contributions — up to the maximum allowed for the year.
You may find it beneficial to keep track of how much money the minor earns each year. This helps you know how much you and others can contribute to the account. It also provides a way to document their earnings, which can be important if the child’s earned income comes through casual sources like mowing lawns and babysitting. You also may need to file a tax return — which can create opportunities to discuss how taxes work and why people get anxious waiting for their refund.
Investment Options
As the account manager, the adult gets to decide how to invest the funds in the custodial Roth IRA. Options include stocks, bonds, mutual funds, exchange-traded funds and alternative investments like cryptocurrency and precious metals.
Key Takeaway
A custodial Roth IRA is more than a savings option for children and teens. It’s a hands-on lesson in compounding and investing, keeping financial records and paying taxes.
FAQ
Here are the answers to some of the most frequently asked questions about Roth IRAs.
What are the contribution limits for a custodial Roth IRA?
The contribution limit for a custodial Roth IRA is the lesser of the total amount of money the child earned or the annual limit set by the IRS. For 2024, the limit is $7,000, but a child who earns $1,000 in 2024 will only be able to contribute $1,000 to the Roth IRA.
Can parents or guardians open a custodial Roth IRA for their child?
Yes, parents or guardians can open a custodial Roth IRA for their child. Grandparents, aunts, uncles, cousins and friends of the family also can open a custodial Roth IRA for children.
What are the age restrictions for contributions to a custodial Roth IRA?
In the past, you were no longer able to contribute to a Roth IRA after you turned 70 1/2. The IRS removed this restriction, so it currently has no age restriction for contributions to a custodial Roth IRA.
Are there income limits for contributing to a custodial Roth IRA?
Yes, there are income limits for contributing to a custodial Roth IRA, this is not an issue for most minors. They can contribute up to the annual maximum as long as their adjusted gross income (which includes money taken out to cover the FICA tax) is less than $138,000. Even though an adult opens and manages the account, the owner's (in this case, the minor) income determines how much they can contribute.
Information is accurate as of April 10, 2024.
This article originally appeared on GOBankingRates.com: Custodial Roth IRAs: What You Need To Know
