Learn more about how custodial Roth IRA accounts work and how they can be useful tools in not just securing your child’s financial future, but also teaching them the importance of saving for retirement.
Definition and Example of a Custodial Roth IRA
A custodial Roth IRA is a retirement account designed for children under age 18. Since most brokerages do not allow minors to open and operate accounts, a custodial Roth IRA is maintained by an adult custodian, usually a parent or guardian until the minor comes of age. Custodial Roth IRA accounts convert to regular Roth IRA accounts, giving all managerial powers to the child once they turn 18 or 21 years of age depending on state regulations. An attractive feature of custodial Roth IRAs is that like a Roth IRA, the account is funded by after-tax dollars, which means the owner can withdraw 100% of funds they deposit at any time without penalty. Distributions from earnings on the contributions made are not taxed, if they meet certain criteria. The same contribution limits that apply to regular Roth IRAs apply to custodial Roth IRAs: a maximum of $6,000 per 2021 and 2022 tax years, or up to the amount of the child’s earned income for the year, whichever is less. Not all brokerages allow opening custodial Roth IRA accounts, so you may have limited options. Charles Schwab and Fidelity are among the few brokerages that offer custodial Roth IRA accounts.
How a Custodial Roth IRA Works
Children often begin earning money by the time they become teens or even before that through babysitting, yard work, or other jobs. Although few people that age are thinking about saving for retirement, a parent or grandparent can teach them the value of planning ahead financially by helping them create a custodial Roth IRA.
Contributions
According to IRS rules, minors for whom custodial Roth IRA accounts are opened need to have earned income, but they don’t necessarily need to be filing taxes. For example, if a teenager earns $3,000 one year by cutting neighbors’ yards and tackling other yard maintenance projects, they may not need to file taxes, but they can deposit the full amount into a custodial Roth IRA. Understandably, teens who work to put money in their pocket don’t usually want to stash it away for 50 or more years. Another way to fund a custodial Roth IRA is through a partial contribution by an adult, perhaps a parent or guardian, if they have the financial resources to do so. While at no point can contributions exceed the lower of the $6,000 IRA annual contribution limit or the child’s earned income for the year, an adult may contribute to the custodial Roth IRA. An arrangement where the child contributes a part of their earnings and a parent matches the contribution could be a good lesson in saving for retirement. It is also important to know that any contributions by an adult to a custodial Roth IRA are considered irrevocable transfers for the benefit of the minor. The adult can’t transfer the money into another account at their own will.
The Power of Time
A custodial IRA could be a great example for a child to learn about the power of compounding as they watch their earnings grow. Time in the market is more powerful (and achievable) than timing the market. For example, let’s assume a child starts contributing the maximum amount of $6,000 to their Roth IRA starting at 15 years of age and continues until they’re 60 years old. That’s 45 years. Considering the returns of the S&P 500 index as a proxy for the growth of the Roth IRA account, the annual rate of return can be pegged at 12% based on S&P 500’s 10-year annualized return as of March 2022. With those assumptions, the Roth IRA contributions totaling $276,000 could grow to more than $9 million over the course of those 45 years. Of course, those numbers are based on a lot of assumptions, and do not take into account any withdrawals, rule changes to contribution limits, or income changes for the minor that may make them ineligible to contribute to the account in the future.
Custodial Roth IRA vs. Custodial Traditional IRA
Just as adults may choose between a Roth IRA or a traditional IRA (or they can hold both), a custodial retirement account can be a Roth IRA or a traditional IRA. The rules of each apply to a custodial IRA, and the Roth IRA rules generally may be better suited for a retirement savings account created for a child. One of the biggest differences between the two plans is the tax advantage. Since Roth IRAs are funded with after-tax dollars, withdrawals that meet certain criteria or qualified distributions are tax-free. If distributions are taken from investment earnings in a Roth IRA or custodial Roth IRA, there may also be tax and penalty consequences. Earnings withdrawn for a Roth IRA account before the age of 59½ years may be subject to a 10% early withdrawal penalty. Roth IRAs, unlike traditional IRAs, do not mandate required minimum distributions from the account after the age of 72 years. That’s another benefit of custodial Roth IRAs converting to a Roth IRA after the minor becomes an adult.
What It Means for Individual Investors
When investing in stocks, time in the market is the most powerful tool one can have. By creating a custodial Roth IRA for someone who is under age 18, you provide them with many years of having money invested in the stock market. It is also a great way to save for big expenses such as paying for college or for when they decide to buy a house. A custodial Roth IRA also helps teach young people the importance of planning for retirement no matter how far away that seems. Learning that lesson before they even hold down a full-time job may help them create positive savings habits.
