When you have children, it seems you can never do enough for them (and when they are teens, you can never do anything right).
Guiding your kids on the path of saving for their future gives them a head start to financial independence. Creating a Roth IRA for kids provides more flexibility for your children before they reach adulthood than other options, as these funds can help pay for college, making a first home purchase, or retirement.
Parents can influence their children’s healthy money habits early by teaching them to save money and spend less to invest for their future. They can open a Roth IRA custodial retirement account at any age so long as their child has earned income.
Differences between 401K and IRA Retirement Accounts
Individual retirement accounts (IRAs) differ from the 401K employer-sponsored retirement plans offered to employees by many companies, often with an employer’s match contribution.
When young people begin working full-time jobs and earning money, many private companies offer 401K plans designed for employees (versus nonprofit organizations offering 403b plans).
Typically, young people begin saving for retirement through automatic payments once they receive paychecks from their first jobs. The 401K plan is the best place to invest for retirement so that you earn your company’s contribution if offered, which is a partial or complete match, and viewed as “free money,” and contribution limits are higher than IRAs.
IRAs are personal retirement accounts that you can set up in addition to the 401K plan or those whose employer doesn’t offer such programs. Individuals create and fund these retirement accounts at their discretion, but they should begin to do so as soon as possible.
A parent can act as a custodian for their child’s IRA account (traditional or Roth IRA) until they reach the age of majority, typically 18 years of age, depending on the state. We will discuss later, they can make contributions limited to the child’s earned income.
Roth IRA vs. Traditional IRA
There are two types of IRAs: Traditional IRA and Roth IRA. The amount contributed to a traditional IRA reduces your tax liability. Investments inside the IRA accumulate tax-free. You owe income taxes upon eventual withdrawals, deferring your tax liabilities for years.
You fund a Roth IRA with after-tax contributions, which grow tax-free. Roth IRA withdrawals are tax-free, unlike the traditional IRA, which requires deferred tax payments at the current tax rate of the account holder. The tax rate will depend on the holder’s income balance from various sources in retirement.
Both traditional IRA and Roth IRA have contribution limits, while there are higher limits for 401K plans.
Benefits of a Roth IRA For Kids
Although you could set up a traditional IRA for your child, the contributions to a Roth IRA benefit from the likelihood that the child’s earned income will have a relatively low tax rate when you’re contributing to their account.
A Roth IRA is preferable to a traditional IRA with after-tax contributions, tax-free growth, and withdrawals. Although it is a retirement account, you can use your account for qualified education expenses. There is no mandatory withdrawal schedule for Roth IRAs (unless you are the beneficiary of the Roth IRA) like traditional IRAs and employer-sponsored accounts, called required minimum distributions (or RMDs) each year, or face taxes and penalties. It’s essentially a no-brainer to establish a Roth IRA for them.
Parents can set up a Roth IRA for their kids until they are 18, requiring an adult to serve as custodians. The custodian maintains control of the child’s Roth IRA, including decisions about contributions, investments, and distributions.
When Your Child Turns The Legal Age
When your child reaches the legal age of your state (usually 18 or 21), their custodial account needs to convert to a regular Roth IRA in their name. Parents are responsible for educating their children about the nature of these funds and that their kids should not make withdrawals for frivolous purchases.
Withdrawals from the Roth IRA are impractical. It is easier said than done. The best argument is that keeping money in the funds long term and continuing to contribute will help the account grow significantly on a compound basis. Using a Roth IRA calculator, you can visualize the benefits of continued contributions and compound growth.
For example, we’ll use these parameters:
- The current balance of $6,000, the parent’s contribution
- Annual contribution of $3,000 ($6,000 is the current limit, and $7,000, aged 50 or above)
- 7% annual investment return
- Current age 18 years and retirement at age 65 years
The balance at age 65 in the Roth IRA is $1,131,947 and is tax-free, or $489,629 more than the balance of the regular taxable saving account. We are being a bit conservative. For example, the contribution should be closer to the $6,000 limit. The 7% return arguably could be higher based on the S&P 500 long-term average return of 10% if you invest in your retirement account in a low-cost index fund market proxy.
When looking at retirement accounts in the short term, when there are severe downturns in the market or a bear market, you may panic and want to sell some securities. These retirement accounts as a last resort to withdraw money for your needs, as these funds are for your child’s financial future.
Defining Earned Income
Contributions to Roth IRA for kids are limited to your minor’s annual earned income. According to the IRS, earned income is compensation for performing personal services, such as salaries, wages, tips, and net earnings from self-employment.
On the other hand, you can’t base your contribution to Roth on unearned income from interest, dividends, or capital gains.
Young children can earn compensation from modeling, advertisements, or acting that parents can contribute to a Roth IRA. Later, kids can have afterschool or summer jobs in restaurants, camps, and supermarkets, resulting in earned income.
For example, our son Tyler earned an income of $2,000 as a camp counselor when he was a minor. He could invest all or part of the $2,000 into the Roth IRA. If he only contributed $1,000, we would contribute another $1,000 into his Roth IRA in that tax year. We cannot contribute more because his $2,000 earnings set the limit.
Had he earned $6,000 as a counselor in the year that the IRS set $6,000 as the annual contribution limit, Tyler and we, as his parents (or other relatives), could have funded the account up to $6,000 that year.
Can A Parent Hire A Child In A Family Business?
It is not unusual for a child to work in their parent’s business and earn some money for their efforts. My brother and I worked at our parents’ hardware and housewares store after school and during summers at young ages. Our tasks changed as we got older, but we unpacked deliveries, cleaned shelves, bagged customer purchases, and made deliveries.
Had my parents paid us (they didn’t pay us except for the random ice cream), my brother and I would have legitimately earned income for a Roth IRA, which didn’t exist until 1998. Traditional IRAs got an early start in 1974.
Thus, income generated from employment, including employment by a parent, is earned income that you may contribute to a Roth IRA. Bring your ten-year child to your office to open and sort your mail, file, or copy documents, and consider contributing their earned income to the custodial Roth IRA. At that age, they may find it fun to help with tasks you don’t want to, but they are capable and willing to help you. (By the time they reach 17 or 18 years old, they only want the keys to the car!)
The parent who made the payment to their kid may be able to deduct the salary from their Federal income taxes. Before doing so, consult with your accountant to ensure that you may do this on your taxes, and ask whether these payments are subject to income tax withholding rates.
According to the IRS, children earning over $12,550 must file their own tax returns.
At age 18, they can set up their own Roth IRA account and contribute up to $6,000 for 2022 or $7,000 at age 50 or above. A Roth IRA is preferable to a traditional IRA with after-tax contributions, tax-free growth, and withdrawals. Early savings allow compound growth over decades, an excellent way to have a healthy retirement.
Your eligibility to contribute to a Roth IRA depends on your income level. MAGI is adjusted gross income (AGI) plus several items that are either exempt, excluded income, or certain deductions. If you are filing as a single person, your Modified Adjusted Gross Income(i.e., MAGI) must be under $144,000 for the tax year 2022, and if you’re married and filing jointly, your MAGI must be under $214,000 that year.
While it would be great for your teenager to continue contributing to their Roth IRA as much as possible, even a portion of their earnings would be a great start, primarily because you provided them with a headstart.
Withdrawals And Qualified Distributions
After your child turns 18 years or the age of majority in the respective state, they may consider using the money from their Roth IRA though they should continue to build the fund through compound benefits. Understanding the rules associated with withdrawals and exceptions to the rule is essential, but we recommend that you always consult your tax accountant due to these complex IRS rules.
Early Roth IRA withdrawals before 59.5 yrs and having this account for at least five years (five-year rule) will trigger ordinary taxes on the distribution of investment earnings and a 10% penalty.
The IRS imposes a 5-year rule that provides a waiting period before you can withdraw money from your Roth IRA. It states the Roth IRA must be at least five years old before removing any of its earnings, even if you are 59.5 years old. Depending on your age and how long you’ve held the account, you may have to pay taxes or penalties (generally 10% of the distributed sum).
Exceptions that may preclude you from paying 10% additional tax on the following qualified distributions as long as you have the account for five years:
- You have reached age 59½.
- Up to 100% of what they contributed at any time and for any reason.
- You are permanently disabled or passed away.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution (up to $10,000) to buy, build, or rebuild your first home.
- The distributions are part of a series of substantially equal payments.
- You have unreimbursed medical expenses exceeding 7.5% of your year’s AGI.
- You are paying medical insurance premiums during a period of unemployment.
- The distributions aren’t more than your qualified higher education expenses.
- The distribution is a qualified reservist distribution.
Gen Zers have been saving for retirement earlier than previous generations, with 70% of Generation Z surveyed having already begun saving for retirement in their 401K plan or outside the workplace.
Besides saving for retirement, you can guide your kids when they are young and fungible to learn how to handle money.
When your kids are young, it is the best time to guide them on the path of saving for their future. By creating a Roth IRA for kids, parents can give them a head start to financial independence and provide them with more flexibility before they reach adulthood by helping them fund retirement.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.