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Do Your Kids Need a Roth IRA?

In this U.S. News & World Report article, Managing Partner, Jeff Winn discusses Roth IRAs & explains what parents should know about when opening a Custodial IRA.

Do Your Kids Need a Roth IRA?

RETIREMENT ACCOUNTS aren’t only for adults. In fact, using a Roth IRA for kids can be an excellent way to not only give children a head start on retirement savings, but also provide a source of cash for college, homeownership or other expenses.

“I would strongly encourage parents to open (one) up for their kids,” says Tim Sullivan, CEO of financial planning firm Strategic Wealth Advisors Group in Utica, Michigan.

Roth IRAs are funded with after-tax dollars, but they grow tax-free and money can be withdrawn tax-free after age 59 ½. Earnings withdrawn prior to age 59 ½ may be subject to a 10% tax penalty. However, contributions may be accessed early without any tax or penalties, making this a versatile way for young people to save money for a variety of future expenses.

However, before you open a Roth IRA for your child, you need to understand the details of how these accounts are set up and can be accessed. Keep reading to learn about the requirements and advantages of these retirement accounts.

What Is a Custodial IRA?

While children of all ages can open a Roth IRA, they can’t do it on their own. “If it’s a child, it has to be a custodial IRA,” Sullivan says. These accounts are offered by most large investment companies, such as Fidelity and Charles Schwab, but may not be available through some online brokerage firms.

A custodial IRA is one in which a parent or other adult manages the assets in the account on behalf of a minor until he or she reaches the age of majority. Although the money in the account is managed by a custodian, it belongs to the child, and their name and Social Security number are listed on the account.

“Practically speaking, parents have to understand it’s going to be the kids’ money once they are 18 or 21, depending on the state,” says Jeff Winn, an Orlando-based managing partner with investment firm International Assets Advisory. Parents lose control over the money at that point, and a child can invest or withdraw the account assets as he or she likes.

Roth IRA Rules for Custodial Accounts

Children of any age can have a retirement account. “As long as they have earned income, they can open a Roth IRA,” says Timothy McGrath, a certified financial planner and managing partner at advisory firm Riverpoint Wealth Management in Chicago.

Earned income is defined by the IRS as taxable employee pay including wages, salaries and tips and includes all income reported on a W-2 tax form. Net earnings from self-employment is also considered earned income. As a result, a child who makes money mowing lawns or babysitting could open a Roth IRA, but one whose only income comes from Social Security or investment dividends cannot open a Roth IRA. Be aware that children who earn money through cash jobs may be responsible for self-employment taxes, and you should consult with a tax professional for guidance on what tax forms may be required of them.

In 2020, workers younger than age 50 can contribute up to $6,000 to an IRA. However, children may be limited by how much earned income they make. Contributions cannot exceed their annual income. “If they only earn $3,000, they can’t contribute $5,000,” Winn says.

That’s true even if parents and grandparents are making contributions to the IRA on a child’s behalf. What’s more, “If parents or grandparents put money into an IRA, they have to consider the gift rule,” says Dawn-Marie Joseph, president of financial planning firm Estate Planning & Preservation in Williamston, Michigan.

Money deposited by a parent into a child’s Roth IRA counts as a gift, and the IRS only allows tax-free gifts of up to $15,000 per person. While it wouldn’t be possible to exceed the gift limit with IRA contributions alone, family members should keep the limit in mind should they plan to give their children other assets during the year.

Advantages of Opening a Roth IRA for Kids

There are three main reasons to consider a Roth IRA for kids:

  • They provide years of compound interest for long-term growth.
  • Roth IRAs allow tax-free withdrawals in retirement.
  • There’s an option to withdraw contributions at any time.

Roth IRAs come with significant tax advantages, and opening one early for children gives them the benefit of compounding interest over decades. A $5,000 initial investment for a 10-year-old could turn into more than $57,000 at age 60, assuming an annual 5% rate of return. All that money can be withdrawn tax-free after age 59 ½ too.

“They’ll accumulate whatever it earns and don’t pay any tax on it,” Joseph says. “That’s a tremendous (tax) savings.”

People need to be cautious about how much money they divert to a child’s IRA though, says Greg Sarian, certified financial planner and partner at the wealth management firm Sarian Strategic Partners at HighTower in Wayne, Pennsylvania. “In our view, they shouldn’t be contributing to their kid’s retirement account until they are contributing to their own,” he explains. “That said, it can be a wonderful gifting opportunity.”

Not only can a Roth IRA help children build a nest egg for retirement, but it can also serve as a source of cash for young adults who need to pay for college or buy a house. Contributions to a Roth IRA can be withdrawn without tax or penalty at any time since that money has already been taxed. This would allow a college student, for example, to withdraw contributions to pay for tuition, while leaving earnings in the account to continue to grow.

However, Roth IRAs are intended for retirement savings and withdrawing contributions early could impact long-term gains. Talk to a financial planning professional to determine how best to use a Roth IRA to pay for your child’s future needs.

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