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Have you ever wished you’d started saving for retirement sooner? With a custodial Roth IRA, you may be able to prevent your child from having the same regret. You can help them set money aside in this account as soon as they have earned income — and that can happen at a much younger age than you might think. Setting up a Roth IRA for your kid can be a good way to help secure their financial future.
How does a custodial Roth IRA work?
Similar to a custodial savings account or 529 plan, a custodial Roth IRA is an account that you set up and manage for your minor child. The money always fully belongs to your child, but you’ll control the account until they reach the age of termination (not the age of majority). Depending on your state, that age can range from 18 to 25 but is usually 21. At that point, your child will get full control of the account. (Learn more: Custodial accounts and Coverdells: How to use them)
Custodial Roth IRA benefits
Kids have the same Roth IRA contribution limits as adults: Up to $6,500 in 2023 or 100 percent of earned income, whichever is less. Roth IRA contributions are taxable — that is, they’re made with after-tax dollars. However, your child’s annual earnings may put them in the 0 percent federal income tax bracket.
A Roth IRA can also offer these tax benefits:
- No tax on growth.
- No tax on qualified distributions of earnings.
- No tax on returned contributions.
- No tax for heirs.
While it’s possible to open a traditional IRA for your child, it’s unlikely to make sense. Traditional IRA contributions are tax deductible, but if your child doesn’t earn enough to have a tax bill, the deduction is worthless — and they’ll pay income tax on all their eventual distributions. (See: 8 FAQs on traditional vs. Roth IRAs)
Investing your child’s Roth contributions
As custodian of your child’s Roth IRA, you’re responsible for managing the money for your child’s benefit.
“The primary intent should be for retirement planning, although there are circumstances where a Roth could be used for education or buying a first home,” said Reed Willet, vice president of the Planning Solutions Group at Coastal Wealth, a MassMutual firm in Fort Lauderdale.
“You always want to make sure the investments chosen align with the overall goals and objectives,” Willet explained. “If the intent is to have the account held for 50 years, you can be more aggressive than if the funds will be used for a shorter-term goal like college funding.”
Flexible distributions
Roth IRAs offer more flexibility than you might think when it comes to taking money out penalty free. Not only can contributions come out at any time, but earnings withdrawn from an IRA count as a qualified distribution in these circumstances:
- Paying for college.
- Buying a first home (up to $10,000).
- Paying medical bills that exceed 7.5 percent of adjusted gross income.
- Covering health insurance premiums while unemployed.
- Taking substantially equal periodic payments.
- Becoming totally and permanently disabled.
- Turning age 59½.
For any of the above to be qualified distributions, five years must have passed from January 1 of the first contribution year. So, if your child’s first contribution was on April 1, 2024, contributions could be withdrawn without penalty beginning January 1, 2029.
Roth IRA drawbacks
It’s natural to be worried about locking up money for decades. But what if your child needs it for something other than a qualified distribution?
“You definitely need to consider the potential that the minor would [later] need the assets for something other than education, a first home, or retirement,” Willett said. “You could easily have a situation where a 25-year-old loses his job with no emergency savings and has to tap into the Roth IRA to meet basic living expenses.”
Contributions could be withdrawn penalty free as long as the five-year requirement has been met. But any nonqualified distributions of earnings would incur ordinary income tax plus a 10 percent tax penalty. And you only have 60 days to repay money taken out of a Roth IRA.
“You definitely would want to have contingencies in place to avoid these types of situations if at all possible,” Willett added. (Learn more: How to set up and maintain an emergency fund)
Legal ways your child can earn income for a Roth IRA
Under federal law, kids younger than 14 can work any of these jobs:
● Parents’ business: For a business owned entirely by the parents, children under age 14 can do any type of work that’s not considered hazardous. For example, children can’t use food slicers or vertical mixers, certain types of power tools, or forklifts. But they can take inventory, create marketing materials, and do many other tasks.
“In the case of the family business, the duties performed must qualify as legitimate — you are not allowed to just put your kids on the payroll,” Willett said. “If executed properly, this can be a way to save on taxes for the business and also set the child up for future financial success.”
● Performing: Child acting on TV shows and in movies might be the first thing that comes to mind here, but there are opportunities in dance, theater, commercials, and social media too. It’s important to consider the lasting psychological impact these types of jobs can have and potential safety issues, as well as whether your child truly enjoys the work.
● Modeling: Child modeling can be challenging to break into and can potentially be harmful under the wrong circumstances. But if your child enjoys posing, takes direction well and you’re comfortable putting their image out there, this work can be lucrative.
● Babysitting: Parents could pay a responsible older child to watch their siblings. Friends and neighbors could also become clients. Community groups and online job boards can make it easy to find gigs and learn what people are paying. These jobs may not be appropriate for younger sitters and you’ll want to help your child vet any opportunity to avoid undesirable situations.
● Doing chores: Getting paid to do minor chores in a private home can help kids become competent in household tasks long before they graduate from college. It doesn’t have to be the parents' home, but if it is, this is one of the easiest ways to help your child generate income while learning the life skills they’ll need as an adult.
● Family farm work: If the parents own a farm, the child can do any type of agricultural work for them at any age.
● Newspaper delivery: Adults driving vehicles typically perform this job these days, but technically, it’s an option for your child.
Both federal and state labor laws restrict the occupations and conditions minors can work in. For example, federal law doesn’t allow 14- or 15-year-olds to work in transportation or construction, unless they’re solely doing office or sales work. And state laws may also restrict the number of hours and times of day kids can work. Massachusetts’ child labor laws, for example, don’t allow kids aged six to eight to work more than five hours a day in the entertainment industry.
Strategies for boosting your child’s Roth contributions
Your child needs earned income to contribute to a Roth. Parent income and gift income don’t count.
But the IRS doesn’t check to see whether the exact dollars your child earns go into the Roth. That means your teenager could use their paycheck to cover their car insurance premiums, and you could contribute matching funds to their Roth IRA. Similarly, a grandparent could use part of their annual gift exclusion to contribute to your child’s Roth IRA. (Related: 5 financial gift ideas for teens and kids)
As far as the IRS is concerned, your child’s income is going into the Roth, and you’re effectively paying their car insurance premiums. But this mental accounting trick can keep your child motivated to work.
They get to use their current income for the short-term gratification of being able to drive. And you (or another relative) get to help them save for the future in an advantageous way. (Learn more: Why saving for retirement early is important)
Building a solid financial foundation for your child
Opening a custodial Roth IRA for your child could give them a major head start on saving for retirement. With so many extra years to earn compound returns, they might enjoy more choices for how to direct their income and what opportunities to pursue when they’re older. They’ll also have the flexibility to withdraw contributions for any purpose, without penalty, in case of emergency.
A downside is that your child will have full control over a potentially large sum of money no later than age 25, which could backfire if they’re irresponsible. It’s also possible that with limited funds, your family might be better off saving and investing in a 529 plan.
Talking about the pros and cons of a Roth IRA for kids with a MassMutual financial professional can help you make a choice you feel confident in.
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