A Roth IRA for kids is a great option for parents who want to secure their child’s future. Here is everything there is to know about it.
In this article:
- How Can Parents Contribute to a Roth IRA for a Child?
- When Should a Parent Open a Roth IRA for Their Kid?
- Who Can Contribute to a Roth IRA for Their Kid?
- What Are the Considerations in Opening a Roth IRA for Kids?
- Why Should I Open a Roth IRA for My Child?
Opening a Roth IRA for Kids | How and Why Parents Should Do It
How Can Parents Contribute to a Roth IRA for a Child?
Probably one of the most common pieces of advice given by financial advisors is about the timing of preparing for retirement — the best time to start saving for retirement is as early as possible. Unfortunately, a lot of younger people easily brush this off or are unaware of this idea.
Luckily, parents can help their children save for retirement by making contributions to a Roth IRA for their child. In fact, by investing modest sums at an early age and taking advantage of the power of compound interest over 40 or more years, parents can gradually help secure their child’s future.
- A parent invests $1,000 in the Roth IRA of a 15-year old today.
- Assuming an 8% annual return, the child could have over $100,000 by the age of 75.
Assuming the same rate of return:
- A parent who invests $5,000 in a 17-year old’s Roth IRA could give his or her child a $500,000 retirement fund by the age of 75.
- Keeping these contributions up for a few years could give the child a million dollars by the time they retire.
When Should a Parent Open a Roth IRA for Their Kid?
As for the question of when it’s best to open a Roth IRA for a child, there’s really no minimum age requirement for opening or contributing to a Roth IRA for kids as long as the kid has earned income. Rather than age, the factor parents should consider more when opening a Roth IRA for kids is income.
Earned Income Definition: The Internal Revenue Service (IRS) defines “earned income” as taxable wages and income excluding investment income. This includes money the child might earn from a W-2 job, or from various self-employment gigs like dog-walking, lawn-mowing, or babysitting.
Who Can Contribute to a Roth IRA for Their Kid?
Parents can contribute to their child’s Roth IRA as long as the child has as much earned income as the total contribution amount.
- A 17-year old working a part-time mall job earned $3,000 last year.
- This means that the parents can fund the IRA up to a maximum of $3,000 for their child.
It is, however, up to the account custodian to document the child’s earnings. This has to include:
- A description of the service rendered
- When the child did the job
- The payment amount, which has to be at a reasonable rate as well. A $1,000 payment for a night of babysitting, for example, isn’t acceptable.
What Are the Considerations in Opening a Roth IRA for Kids?
While earned income is the primary consideration in opening a Roth IRA for kids, there are also other things that one needs to take into account.
1. Contribution Limits
The 2019 Roth IRA contribution limit is either $6,000, or the total earned income for the year, whichever is lower.
- Total Earned Income — This means that the Roth IRA of a child who earned $2,000 from babysitting can only be funded up to $2,000.
- 2019 Roth IRA Contribution Limit — On the other hand, a child who earned $7,000 from commercial advertisements, for example, can only contribute up to $6,000 in his or her Roth IRA.
2. It Should Be a Custodial Roth IRA
The income of the child is the primary qualification for opening a Roth IRA. However, fund companies or brokerages require that a parent or another adult help in opening the account.
Providers of Roth IRAs typically require that an adult open a custodial account for the minor and manage it.
Fortunately, the process is fairly simple. It only requires both the child and the adult to provide details, like birthdates, addresses, Social Security numbers, and other similar personal information.
Why Should I Open a Roth IRA for My Child?
Opening a Roth IRA for one’s child offers several benefits. Here are some of the reasons why it can be advantageous to open a Roth IRA for kids:
1. Can Withdraw Contributions at Any Time
The majority of retirement accounts have strict rules on distributions. A lot of these accounts charge a penalty of 10% for withdrawals before the age of 59 1/2.
For children who might want to use this at an earlier age, this can be a disadvantage. Such is not the case for Roth IRAs.
Children can withdraw the money they contribute at any given time.
It is, however, balanced by the stricter rules imposed on the account’s earnings (the return on the contributions invested). The IRS may tax as income distributions of Roth IRA investment earnings, as well as penalize them with an early distribution tax of 10% or both.
This makes a Roth IRA a better middle ground for kids who want or may need the cash and parents who want to help secure their child’s future.
2. More Time Means More Growth
Compound interest allows the money invested in a Roth IRA to grow exponentially. This means that, for children, this money can grow over a longer time horizon compared to adults who typically start investing at the age of 35 or 40.
Children who invest their money in a Roth IRA and leave it untouched until retirement could have as much as 50 or more years of tax-free investment growth.
Assuming monthly compounding and a 6% return on investment, after 60 years, a one-time $6,000 contribution to a Roth IRA could then amount to about $200,000.
3. Investing Easily Beats Saving
For children, the more traditional choice of handling money is saving it in a normal savings account. This type of account is more flexible and doesn’t require one to have an earned income.
However, the exponential growth Roth IRAs enjoy doesn’t typically happen in a regular savings account. It allows one to choose his or her investments.
In the long run, this leads to the type of growth described above.
At present, savings accounts pay out more or less the same flat interest rates, which are approximately only at 0.09% currently. At this rate, after 60 years, the same $6,000 one-time deposit into a savings account will not even double.
4. There Are Lots of Great Tax Advantages for Kids
Since there’s no tax break for putting money into a Roth IRA, qualified distributions one receives during his or her retirement are also not taxed. Assuming investors follow distribution rules, they can earn that growth completely free of taxes.
This type of treatment towards taxes is essential, especially in a longer time horizon and a lower present tax rate.
Additionally, the earnings of most kids are often low enough so that they need to pay little to no taxes on income at all. This makes it possible for them to avoid taxes charged on contributions.
5. One Can Use the Money for Things Other Than Retirement
Often, a Roth IRA serves as a retirement account. Ideally, this means that one sits on this investment account and allows it to continuously grow over time.
However, it’s also worth noting that Roth IRAs are not just for one’s retirement. As previously mentioned, one can pull out contributions at any time and for any reason.
Additionally, the investor can also have access to investment earnings even before reaching 59 1/2 years old if they meet the following criteria:
- The investor can withdraw as much as $10,000 in earnings. One can use these earnings to buy their first home, free of taxes and penalties as long as the account has been funded for five years.
- The child can also use the earnings of the Roth IRA for qualified education expenses, such as college tuition. While the IRS will tax distributed earnings as income, no penalty charges apply.
Opening a Roth IRA for kids can be a great alternative to traditional savings accounts, especially for kids who are already earning an income even from a young age. It’s a fast-growing investment option that parents can consider in helping their children secure their future.
Are you considering opening a Roth IRA for kids? What are some of your questions about it? Ask us in the comments section below!
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