A custodial Roth IRA is a type of individual retirement account held by a custodian, usually a parent, on behalf of a minor. This allows the child to contribute after-tax income toward their retirement. The account is managed by the custodian until the child reaches the age of majority in their state.
Custodial Roth IRA Rules
Like other IRAs, custodial IRAs can either be opened as traditional IRAs or Roth IRAs. A Custodial traditional IRA is an account that you invest before-tax dollars which grow tax-deferred until retirement.
A custodial Roth IRA is a retirement account where you invest after-tax dollars into which grow without taxes until they are withdrawn in retirement tax-free.
Qualifications
To be eligible for a custodial IRA, a child has to be under 18 or 21 years of age, depending on what age their state considers the 'age of majority.'
But that doesn't mean they can contribute to a custodial Roth IRA solely because they're in the right age bracket. To make contributions, the child must earn income and they can only make contributions equivalent to the income they earn up to the contribution limit, which is $6,000 in 2022.
Takeaway: That means that most parents can't open a custodial IRA for a newborn or young child since they typically are not earning income.
Contribution Limits
The same contribution limits apply to custodial Roth IRAs as regular IRAs - up to $6,000 for those under 50 years old. However, Roth IRA contributions are tied to income. Those who make under $129,000 can contribute the full $6,000. Since the child is not covered by a retirement plan at work, Traditional IRA contributions are allowed.
Withdrawal Rules
The typical Roth IRA withdrawal rules apply to a custodial IRA as to a normal IRA. With a Roth IRA, there are typically no fees or taxes for early withdrawals with one important exception. Investors cannot withdraw funds in the first five years after they make a contribution starting on January 1 of the year that the contribution was made. If an investor withdraws their funds earlier, they could be required to pay a 10% withdrawal fee.
There are exceptions to that rule and ways to withdraw funds without penalties. For example, a plan holder can withdraw funds to pay for qualified higher education expenses for themselves or eligible family members. They can also make withdrawals for medical expenses if their medical costs exceed 10% of their income, and they can use the funds to pay for health insurance premiums if they are unemployed. They can also withdraw up to $10,000 to purchase a home without taxes or penalty.
Benefits of Opening a Roth IRA for a Minor
Wondering what benefits children get from a custodial Roth IRA?
- Compound interest: By starting to save earlier for retirement, children have to put aside less throughout their lives since compound interest helps their funds grow.
- Educational expenses: Funds in a Roth IRA can be used to pay for college and grow tax-free.
- Down payment fund: $10,000 in Roth IRA funds can be used towards a down payment on a home.
- Financial literacy: Opening an IRA for a child can help them learn about the importance of saving and investing.
- Developing health habits: Teaching children to save and invest a portion of their salary can set create a habit that will help them achieve future financial goals.
Traditional IRAs for Kids
While custodial Roth IRAs are more common, parents or guardians can also open up a custodial traditional IRA for children. Traditional IRAs do not have an income limit tied to contributions and investors can deduct up to $6,000 in contributions towards a traditional IRA on their taxes so long as the investor does not have a 401k retirement plan from their employer.
However, children are unlikely to have significant tax obligations because they aren't likely to make a high enough income to while minors. That, therefore, means that they'll be less likely to be able to take advantage of any tax deductions from a traditional IRA account. Despite not getting a deduction, they would still be required to pay taxes on their withdrawals from their traditional IRA when they retire.
In addition, in the case of a traditional IRA, there is a 10% penalty for withdrawing funds before the owner of the IRA turns 59 and a half. Also, any withdrawal from a custodial traditional IRA could also be taxed at the individual's marginal rate.
Takeaway: The lack of a deduction and the withdrawal penalties make traditional IRAs a less attractive savings vehicle for kids since they don't allow as much flexibility and create a larger tax burden at retirement.
Where To Open a Custodial Roth IRA Account
Most financial institutions that offer non-custodial IRAs will also offer a custodial IRA. That includes:
- Banks
- Credit unions
- Investment firms
- Other companies that sell retirement plans to individuals
How To Start a Roth IRA For a Child
Opening a custodial Roth IRA for a child is easy. Just follow these steps:
Step 1: Decide Between a Roth IRA and a Traditional IRA
Before opening an account, guardians should compare Roth IRAs and traditional IRAs and weigh the benefits and costs of each. A Roth IRA provides more flexibility and is likely the better choice since children likely don't have significant tax obligations so they wouldn't be able to take advantage of the traditional IRA deduction. However, a parent might want to make an investment that their children can only access under limited circ*mstances like to pay for college, a down payment, or to fund their retirement. In that case, a traditional IRA might be the better choice.
Step 2: Choose the Custodian
Typically, the custodian is a parent. However, it could also be a child's guardian, grandparent, or a bank or trust company. The custodian will be in charge of managing the money until the child reaches the age of majority, so it's critical that whoever is chosen is trustworthy.
Step 3: Decide on a Plan
Like other IRAs, there can be significant variation between plans. The plan holder can have access to different kinds of investment options by opening a plan at different institutions including mutual funds, securities, bonds, and other types of investments. It's important to look into several plan options before deciding which is the best fit for the child based on the goals of the plan.
Bottom Line
A custodial IRA is a great investment option to help children save for college, their first home, retirement - or a rainy day. They're also a great way to teach kids about saving and investing. By starting early, children get the benefits of compound interest to help them accumulate more money towards their future financial goals.
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