All You Need to Know about Custodial Roth IRA

Custodial Roth IRAs are a distinctive financial planning tool for the next generation, offering unique tax benefits.

In a custodial Roth IRA, an adult—typically a parent—establishes the account for a minor. The minor becomes the sole owner of the account when they reach legal adulthood, which is generally age 18 or 21, depending on the state. Custodial Roth IRAs not only provide tax advantages for retirement but also allow for tax-free and penalty-free withdrawals later in life.

Here’s a comprehensive overview of custodial Roth IRAs and how to set one up:

What is a custodial Roth IRA?

A custodial Roth IRA enables the minor account holder to contribute after-tax dollars towards their retirement. In essence, it functions similarly to a regular Roth IRA.

The key distinction is that custodial Roth IRAs require an adult custodian, as the account involves a minor. This custodian manages the account until the minor reaches the age of majority.

Custodial Roth IRA rules

If you’re familiar with Roth IRAs, you’re already aware of their basic rules. However, custodial Roth IRAs have specific guidelines tailored for accounts held by minors. Here’s what you need to know:

Eligibility

To open a custodial Roth IRA, your child must have earned income. This income can come from employment or self-employment activities, such as babysitting. As long as the child earns money and pays taxes on it, they are eligible to contribute to a custodial Roth IRA.

Contribution limits

For 2024, the maximum contribution limit for custodial Roth IRAs is $7,000 or the total amount of the child’s earned income for the year, whichever is lower. For instance, if your child earned $4,000 from a part-time job, they can contribute up to $4,000 to their custodial Roth IRA. If they earned $8,000, the contribution limit would be capped at $7,000.

Tax implications

Custodial Roth IRAs are funded with after-tax dollars, meaning the money has already been taxed. Therefore, when your child withdraws funds in retirement, they will not owe income tax on these withdrawals, unlike with traditional IRAs.

Switching to a regular Roth IRA

While your child is underage, the custodian manages the account. Once your child reaches the legal age in your state (typically 18 or 21), the custodial Roth IRA must be converted to a regular Roth IRA in their name. Ensure your child understands the conversion process and knows how to continue making contributions.

Withdrawals

Ideally, withdrawals from the custodial Roth IRA should be reserved for retirement. However, if your child needs to withdraw funds before retirement, they can do so without penalties on their contributions. If they withdraw earnings before retirement, taxes and penalties may apply. Withdrawals must be used for the benefit of the child.

Types of IRAs for kids

Children have alternatives to custodial Roth IRAs, such as traditional IRAs. With a traditional IRA, contributions and earnings are made with pre-tax dollars, meaning your child would face taxes on withdrawals during retirement.

However, opting for a traditional IRA over a Roth IRA for children is generally less advantageous. Traditional IRAs are geared toward individuals in higher tax brackets, offering upfront tax deductions that are less relevant for children who typically earn modest incomes. By using a Roth IRA, your child pays taxes at their current lower rate, allowing their investments to grow tax-free for decades. When they withdraw the funds in retirement, they won’t owe any additional taxes, even if their income increases.

How to open a Roth IRA for your kids

Ready to set up a custodial Roth IRA for your child? Here’s a step-by-step guide to get started:

• Choose a Provider: Research financial institutions that offer custodial Roth IRAs, such as Fidelity Investments and Charles Schwab. Compare their features to find the best fit for your needs.
• Open the Account: Once you’ve selected a provider, you can open the account online in just a few minutes. You’ll need to provide basic information about both yourself and your child, including Social Security numbers, employment details, annual income, and banking information.
• Decide on Contributions: After setting up the account, work with your child to decide how much they’ll contribute and how often. You can even match their contributions, as long as the total contributions don’t exceed their annual earnings.

The benefits of opening a Roth IRA for your kids

A custodial Roth IRA offers several advantages for your child:

• Long-Term Growth: By starting early, your child’s money can grow tax-free for decades, potentially resulting in a substantial nest egg for retirement.
• Financial Education: A Roth IRA helps instill good financial habits from a young age, teaching the importance of saving for retirement.
• Flexible Withdrawals: While designed for retirement, Roth IRAs also allow penalty-free withdrawals for other purposes, such as emergencies, college expenses, or purchasing a home.

Custodial IRA vs. traditional IRA

A custodial IRA can be either a traditional or Roth IRA, each with its own set of rules. A Roth IRA is often the better choice for children:

• Roth IRA: Funded with post-tax dollars, contributions can be withdrawn anytime without taxes or penalties. However, earnings are subject to taxes and penalties if withdrawn before age 59½.
• Traditional IRA: Contributions are made with pre-tax dollars and are taxed upon withdrawal. This type of account defers taxes to the future, which might not be as beneficial for children with low current incomes.

In Conclusion

Custodial IRAs provide a valuable head start in financial planning for your children. By introducing them to investment principles early, you can help set them up for a secure financial future and ensure they understand the importance of saving for retirement.