“Starting Children’s Retirement – Revisited”

In August of last year, we wrote a post titled “Setting Your Children Up for Retirement” which you can find here.  In this article, we wanted to dive in deeper to this concept of a Custodial IRA (sometimes called a minor IRA).  I also want to stress that this is clearly not the only way to assist your children (or grandchildren) with their financial future.  However, it is a great way for them to begin developing working skills and to also see the power and effect of compound interest.  Additionally, we want to suggest that if someone is interested and disciplined enough to take the steps we lay out here, that a Roth IRA is one of the most powerful tools to choose for your children.  There are many factors to consider when determining if you are eligible to contribute to an IRA on your child’s behalf.

First, what is a Custodial IRA?

An IRA is an individual retirement account. It enables you to save for retirement outside of an employer-sponsored plan.  A Roth IRA designates how your money is invested for tax purposes. For this type of an account, you contribute post-tax dollars.  As soon as your child has earned income, you can open a Minor Roth IRA on their behalf.

The money invested in this account will grow tax-free until your child reaches retirement age. This means that they will be able to withdraw the money from the account without paying taxes or penalties on the earnings – as long as they are at least 59-1/2 years old and have held the Roth IRA for five years.  Contributions to the account can always be withdrawn tax and penalty free. However, if they need to withdraw earnings before their age and time requirements have been met, they will pay ordinary income taxes and a 10% penalty on the earnings. There can be exceptions to the penalty if they are using the funds toward education, health care expenses, or a first-time home purchase.

What are the Contribution Limits?

You will have a maximum amount that you can put into your Roth IRA or your child’s Roth IRA for every tax year. The IRS announces if there will be an increased contribution limit for the following tax year each year.  For 2021, an individual under the age of 50 can contribute up to a maximum of $6,000, while an individual aged 50 or older can contribute up to a maximum of $7,000. Your contribution will need to be either the amount of the limit or the amount of your earned income, whichever is lower.

Example: You must earn at least as much as you contribute to your IRA. For instance, if you earn $6,000 or more during 2021, then you can contribute the maximum contribution of $6,000 for the tax year. However, if you earn $3,000 during 2021, then you can only contribute up to $3,000.

How can my child become eligible for a minor Roth IRA?

Here are the three things that must be done for your child to become eligible to contribute to a Roth IRA, even if you are contributing the money on their behalf.

#1: Your child must have earned income

Even if they do not bring home a paycheck, your child must have some type of employment compensation.  If you have a business, and your children legitimately help with administrative duties that you could reasonably pay someone else to do, then this work can qualify for the child’s “earned income”. Some business owners even pay their children to model for photos used on their marketing materials.  Of course, if your minor child isn’t working directly with your business, but they have other earned income from various sources outside of the home, then that would also qualify towards “earned income.”

In previous posts, we also mentioned the possibility of counting regular household chores that your children perform as qualifying for “earned income”.  It should be noted that this is certainly a “gray area” in the tax code, and we encourage you to consult a tax professional if you have further questions on this specific area.

#2: You must open the account on your child’s behalf

Because your child is a minor, a parent or custodian must open the Roth IRA on their behalf. They are responsible for contributing to the account and investing the money for the child in their best interest.

At the age of eighteen, the account can be transferred into the former minor’s name. It will be designated as “Roth IRA” rather than “Minor Roth IRA,” and they will have full control.  This is an important note for guardians to realize.  The children will have complete control of this account when they reach the age of majority.

#3: You must adhere to the contribution limits

As mentioned above, the IRS sets contribution limits to Roth IRAs. Your child may not contribute more than they earn to the account while also not exceeding the contribution limit. The contributions can come directly from the child’s earnings, or a parent or other adult can contribute money on their behalf.

What are the benefits of my child having a Roth IRA?

Good Fit for Children

Children are not eligible for the tax deduction associated with a traditional IRA because their annual incomes are typically lower than the standard deduction, which makes a Roth IRA the perfect fit.

Compound interest

A Roth IRA is a powerful tool for young investors who have many years until retirement. The earlier contributions are made, the more time they have to grow.  For example, if a 15-year-old is able to amass $5,000 into a Roth IRA account that grows at a 7% rate of return, they would have over $163,000 in savings by the time they reach age 65.  This assumes they NEVER same another dime in this account after the age of 15!  What a wonderful lesson in compounding for your children.

Tax advantages

A Roth IRA is perfect for those who will be in a higher tax bracket during retirement. When they take the money out, they will be keeping more of it because they do not have to pay taxes on it.

Flexible use of funds

Roth IRAs allow contributions to be withdrawn at any time. After five years, the funds can be used for a first-time home purchase without resulting in taxes or penalties. In addition, qualified education expenses can be withdrawn penalty-free by just paying income tax.

Whether you have children yourself, or simply minors who you want to set up well for the future, the considerations above can be a great way for them to begin the process of saving for their retirement years!