A custodial Roth IRA is a retirement savings account that an adult can open on behalf of a minor child.
To open a custodial Roth IRA, the minor needs to be earning an income (either through an employer or entrepreneurial jobs like babysitting).
Custodial Roth IRA savings can be used for some expenses outside retirement (like buying a car, paying for college or buying a home ), provided your child meets the distribution stipulations (like the 5-year rule and meeting qualifying events).
Compound interest is a powerful financial tool. When you have a long time to let money grow, even a modest amount of savings can turn into a substantial nest egg. Parents familiar with this concept often put it to work for their children by investing on their behalf when they are young. One option that can pay dividends many years into the future is opening a custodial Roth IRA in the child’s name.
Here’s more information on what a custodial Roth IRA is and why it can be a huge help to a child later in life.
What is a custodial Roth IRA?
A custodial Roth IRA is a type of retirement account that a parent or guardian can open on behalf of a minor. The parent or guardian opens and controls the account while the child is a minor. Once the child turns 18 or 25 (depending on the state), parents give up control of the account, which then becomes a regular non-custodial Roth IRA.
What is the difference between a Roth IRA and a custodial Roth IRA?
A Roth IRA and a custodial IRA function quite similarly, except that while a child is still a minor, an adult serves as the custodian of the account on the child’s behalf. Like a Roth IRA, the custodial Roth IRA allows the account owner to make contributions that have already been taxed and withdraw funds tax-free in the future.
Custodial Roth IRA vs. traditional IRA
As with a Roth IRA, contributions to a custodial Roth IRA are made post-tax, meaning your child won’t have to pay income taxes when withdrawing the money in retirement. With a traditional IRA, you make contributions with pre-tax income and then pay taxes when you withdraw the funds at whatever current tax bracket you’re in. Because your child is likely to be in a higher tax bracket at retirement age than in their teen years, a custodial Roth IRA typically makes more sense financially.
Custodial Roth IRA rules
As long as you follow the regulations, a Roth IRA can be a great tax-advantaged way for your child to save. But there are some rules you’ll have to follow.
Who can contribute to a custodial Roth IRA?
To be eligible for a Roth IRA, your child needs to earn an income either with an employer that distributes a W2 or through entrepreneurial pursuits like babysitting, dog walking or landscaping. It’s important to keep track of how much your child is making, as this will have an impact on how much they are eligible to contribute to the Roth IRA.
You’ll want to keep track of details related to your child’s income, like when the work was performed, what type of work they did and for whom and how much your child was paid. A W2 will do this for you if your child works for an employer, but with an independent job, you’ll likely need to keep your own records.
You or other family members can also make contributions to a child’s Roth IRA. Many parents choose to “match” their child’s contributions. For example, if your child contributed $3,000 throughout the year, you may choose to also contribute $3,000 for a total of $6,000 in contributions that year. While contributing, however, you will need to be mindful that you don’t exceed the annual contribution limit.
How much can you contribute to your child’s custodial Roth IRA?
Roth IRA contribution limits change annually. In 2023, contributions cannot exceed $6,500. If your child earns less than $6,500 a year, they are able to only contribute as much as they earn.
For example, if your daughter made $5,000 babysitting, she would be eligible to contribute up to $5,000 to her custodial Roth IRA in a given year. However, if she made $7,500 one year, she would still be able to contribute only $6,500 that year.
Contribution limits apply to both what your child would contribute and what you may choose to contribute as a “match” or gift.
How are custodial Roth IRAs taxed?
As with any Roth IRA, money is taxed before it goes into the account and then grows tax-free as long as it stays in the account. When your child takes funds out later in life, any earnings will not be taxed as long as your child has owned the account for five years and met the qualifying criteria. This is why a custodial Roth IRA is so advantageous for a kid: They’re probably at the lowest tax bracket they’ll ever be in over the course of their lives.
How do withdrawals work with a custodial IRA?
Once your child reaches retirement (age 59½), they will be able to withdraw any funds from the account tax- and penalty-free (as long as they’ve owned the account for at least five years). One huge benefit of a custodial Roth IRA, though, is that they could withdraw some funds prior to retirement to fund other important life milestones.
Once your child has been funding the account for at least five years, they could take out any of their contributions with no income tax or tax penalties to use for any reason—like purchasing a first car or paying for a wedding. There may also be some situations (like buying a first-time home or using the money for qualified education expenses), where your child could take out earnings, too, without additional taxes (provided they meet the qualifications for the withdrawal).
How to set up a custodial IRA for your child
The most time-consuming part of setting up an IRA for your child will likely be doing research into which institution you’d like to use to open the IRA. Once you’ve selected an institution, you’ll apply for the IRA. As part of your application, they’ll probably collect Social Security numbers, birth and residency information, annual income and other personal information about you and your child.
Once the account is opened, you’ll likely want to discuss with your child when they will contribute and how much. If you’re planning to create a “match” for your child’s contributions, you can discuss the details of that arrangement as well. Helping your child understand how the account works can also open the door for conversations about financial literacy and ensure a smooth transition when they assume ownership as an adult.
As the custodian on the account, you’ll be responsible for managing your child’s assets until they reach the age of maturity. You’ll have to set up the account’s portfolio and decide which funds to invest in. You’ll also be responsible for tracking your child’s income and other contributions to make sure you’re within the allowed limit for the year. Although these will be your responsibilities, involving your child in as much of the process as possible can help them feel some ownership over the account and learn more about how to save.
What happens to a custodial account when the child turns 18?
Once your child reaches the legal age in your state, you’ll need to convert the custodial Roth IRA to a regular Roth IRA in the child’s name. Once you convert the account, it’s especially important to talk with your child about details of the account and help them develop a plan to continue making contributions (if you haven’t done so already).
How a custodial IRA can lay a financial foundation
Even if they can’t afford to contribute much now, starting to save for retirement at a young age allows your child to take advantage of many decades’ worth of growth through the power of compound interest.
Opening a custodial Roth IRA is also an opportunity to teach your child how to manage their money as well as the importance of saving for their future. Consider encouraging them to set up an automatic deposit from their paycheck to instill the habit of saving versus spending.
Discussions about a custodial Roth IRA can also springboard into other important financial conversations you may want to have with your child—like how they’re going to pay for college. If you’ve been contributing to a 529, you could begin to discuss details about how you’ll pay for college, what your child will be responsible for and whether they’ll need to file a FAFSA or take out any student loans.
If you need help developing savings plans for a custodial Roth IRA or other savings needs for your children, a Northwestern Mutual financial advisor can help review your situation and facilitate conversations with the whole family.
All investments carry some level of risk including the potential loss of all money invested.
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