Custodial Roth IRA (2024)

Key points

• Custodial Roth IRAs are retirement savings accounts adults establish and maintain for minors.
• Investing early is an excellent way to build wealth.
• A custodial Roth IRA can help you introduce your child to the concept of investing.

As a kid or teen, saving for retirement probably never crossed your mind. But starting to build a nest egg early can have huge benefits. That’s because the earlier you begin, the more your money can grow through compound interest.

A custodial Roth IRA, or individual retirement account, can introduce your kid to investing and give them a financial advantage down the line thanks to the power of compound interest. So let’s learn how this account works, how it differs from a custodial traditional IRA and more.

How does a custodial Roth IRA work?

With a custodial Roth IRA, a parent or another adult opens a retirement savings account on behalf of a minor.

“Age doesn’t matter, but kids must fund their IRA with earned income — not gift money or allowances,” said Pam Krueger, founder and CEO of Wealthramp. “A custodial Roth IRA is a potentially great way to jump-start your child’s savings and teach them about investing. However, to qualify as a Roth, the earnings used to fund the account must be contributed after tax.”

As an account custodian, you’ll be responsible for contributions, investments and other decisions. But the child is the account owner. The assets will be transferred to them once they reach a certain age, usually 18 or 21, depending on the rules in your state.

To be eligible for an account, a child must have earned income. But that doesn’t necessarily mean a full-time job or being formally employed by a company. If your entrepreneurial teen makes $1,500 mowing lawns and babysitting in your neighborhood, you can contribute up to $1,500 to their custodial Roth IRA.

Custodial Roth IRA vs. custodial traditional IRA

You have two options if you’re considering a custodial IRA for your child:

1. Roth: Contributions are made after tax and therefore are not tax deductible in the year you make them. But your child will get the benefit of tax-free withdrawals in retirement.
2. Traditional: Contributions are made with pretax dollars, so they are generally tax deductible in the year they’re made. But withdrawals will be taxed during retirement.

A custodial Roth IRA often makes the most sense for a minor. That’s because your child is likely in a very low tax bracket and won’t necessarily benefit from the current-year tax deduction a traditional IRA could provide. But every situation is different, so consider talking with a tax professional before you decide.

Why it’s good for the kids

A custodial Roth IRA is one of the best ways to introduce kids to saving and investing.

“The money will have years to grow and compound. You are leveraging the power of compound interest, and dollar-cost averaging over decades can jump-start a child’s financial future,” Krueger said.

Dollar-cost averaging is the practice of investing a set amount of money at regular intervals.

To better explain compound interest, let’s return to our example of the teen making $1,500 babysitting and mowing lawns. Here’s what that contribution would look like over the years, assuming a 7% annual return.

Examples of compound interest on $1,500 investment

The compound interest nearly doubles the balance each decade it’s stashed away.

Now here’s a look at how a $5,000 contribution to your teen’s custodial Roth IRA might grow over time, also assuming a 7% annual return.

Examples of compound interest on $5,000 investment

After 40 years, that single investment of $5,000 is nearly 15 times larger just by letting compound interest work its magic.

And there’s another benefit.

“Opening a custodial Roth IRA is a great opportunity to discuss finances with your child,” said Kevin L. Matthews II, a former financial advisor and founder of investing education company BuildingBread. “There is something to be said for the compounding wisdom of experience that your child can gain. A 10-year-old child starting with a custodial Roth IRA today would have 20 years of investing experience and compounding interest behind them at age 30.”

Custodial Roth IRA rules

You already know your teen needs to have earned income to be eligible for a custodial Roth IRA. But there are other rules to be aware of.

Contribution limits

Even if your teen earns $100,000 annually as a TikTok influencer, you’ll be subject to a contribution limit with a custodial Roth IRA. That limit is $7,000 for savers under age 50 in 2024.

Tax treatment

Contributions will be made with post-tax dollars if you opt for a custodial Roth IRA. While there are no immediate tax breaks, withdrawals in retirement won’t be taxed, so the future benefits can be big. And unless your child is one of those aforementioned TikTok influencers, their income is likely low enough that they aren’t paying much, if any, tax in the present.

Withdrawals

It would be great if your teen kept their Roth IRA as an investment vehicle. But there may come a time prior to retirement that they need to make a withdrawal. Thus, you should know about the taxes and penalties on early Roth IRA withdrawals.

Roth IRA contributions can be withdrawn anytime tax- and penalty-free because they’re made with income you’ve already paid taxes on. That differs from a traditional IRA, where you owe taxes on the money you’re contributing because you took a deduction.

But early withdrawals of Roth IRA earnings may trigger taxes and a 10% penalty. To withdraw Roth IRA earnings both tax- and penalty-free, the account holder generally must be at least 59½ and have held the account for five years or more.

There are exceptions to the 10% penalty on early withdrawals, including in the following circ*mstances:

• Total and permanent disability.
• Qualified first-time home purchases.
• Qualified higher education expenses.
• Certain medical expenses.

Some of these exceptions may be especially relevant to a teenager, most notably the ability to withdraw earnings early to pay for tuition or other qualified higher education expenses.

Account transfer

Once your child turns 18 or 21, depending on where you live, the assets in the custodial Roth IRA must be transferred to a new account in their name. At that point, your child will be responsible for managing contributions and investments and making other account decisions.

How to open a Roth IRA

If you decide a custodial Roth IRA is right for your family, you can open one through many major online brokers, including Fidelity, Vanguard, Charles Schwab and TD Ameritrade.

To open an account, you’ll typically need to complete an application, often available online. You’ll provide personal information like your name, address, Social Security number and driver’s license number. You may need to provide similar information for your child as well.

Once you submit your application, you’ll wait to receive an official notification from the brokerage that your account is active. Then, you can start contributing.

Are custodial Roth IRAs insured?

Not all IRAs are insured by the Federal Deposit Insurance Corporation. The FDIC protects deposit accounts at FDIC-insured institutions up to $250,000. So if your custodial Roth IRA includes a checking account, a savings account or another deposit product, that portion will be insured by the FDIC. But if your custodial Roth IRA is invested in only securities, it will not be covered.

Frequently asked questions (FAQs)