Can I Open a Roth IRA for My Kids?
The most common regret investors have is not investing more, sooner.
Naturally, many investors who have children with decades ahead to allow compounding interest to grow are interested in learning how they can set their kids up well for the future by opening a Roth IRA for them early in life.
And it’s not a bad idea.
If you’ve ever looked at a chart illustrating the growth of any investment over time, you know the last years of the investment’s life produce the most exciting returns.
In fact, if you were able to invest just $1,000 for a child at birth, it would be worth almost $150,000 by the time they reach age 65 with an average annual return of 8%.
If you invested the maximum annual contribution of $6,500, it would be worth just under $1MM at $967,000.
Granted, 65 years is a long time for a payoff, but that’s almost $1MM of which only 0.6% was cash that had to be invested.
The best part? If this were in a Roth IRA it would be completely tax-free.
Not only that, but the income tax rate for a child is almost certainly in the lowest bracket at a mere 10%*. It’s a near certainty that they’ll never see income taxes that low again, ever.
(Remember, there is no standard deduction if you are claimed as a dependent on your parent’s taxes, so no 0% tax break for the kiddos.)
Having covered all of that, it’s still not as simple as just contacting your brokerage and opening a Roth IRA for your child.
Here are several things to remember if you want to open a Roth IRA for your children.
They Must Have Earned Income
One great feature of IRAs is the ability to make contributions at any age.
It doesn’t matter if you’re 100 minutes old or 100 years old, your age alone does not disqualify you from contributing to an IRA.
The one thing you must have, at any age, is earned income.
The good news is this is the only qualifier for IRA eligibility. The bad news is most children don’t have earned income; especially not any that’s reported to the IRS.
This could deal a fatal blow to your plans for a custodial Roth IRA and it is an especially difficult hurdle to clear for very young children.
Outside of being a child performer of some sort or being selected as a model for Gerber’s next jar of baby food, there just aren’t a ton of job options out there for kids.
The older they get, the easier it will be to find meaningful employment, but don’t give in to any temptation to “create” income from them out of thin air.
If you have a business, your kids can provide work and be paid for those services, but the compensation must be reasonable for the activity.
In other words, you can’t pay your kids $100 an hour to sweep floors, take out trash, or even organize files unless you can illustrate that it would cost you that much to hire out that work elsewhere.
Resist the temptation to game the system here.
Yes, it would be nice to get a Roth IRA going for your kids, but it’s not worth getting yourself into an audit situation with the IRS.
The Kids Cannot Contribute More Than Their MAGI
In addition to needing earned income, your kids cannot contribute more than they’ll make in a year or the annual contribution limit of $7,000 (in 2024).
That’s quite a bit of earned income for someone whose primary responsibility in life should probably still be school, but many parents elect to make all or part of the contributions to their kid’s Roth IRAs on their behalf.
Think of it like an employer match in a 401(k) plan. The more they earn, the more goes into their accounts.
But don’t forget…
Once They Reach 18, It’s Theirs
As the parent and creator of the Custodial Roth IRA, you will have control over the account until your child turns 18.
But then, it’s all theirs.
This means if your kid turns 18 and decides to withdraw every penny, pay income taxes and penalties on the withdrawal, and blow it all on their senior class trip, they can do it.
If they decide to spend it on a car, a computer, or a membership to the Jelly of the Month club, they can do it.
But it also means they’ll have an amazing opportunity and a head start on saving for retirement.
Benefits of Custodial Roth IRAs
There are several additional characteristics of Roth IRAs that are particularly beneficial for young people.
Years of Growth
We’ve touched on this several times already, but it can’t be overstated how beneficial time is for the growth of any investment.
Compounding interest is a key ingredient for successful investing, but it’s of little consequence without time.
A normal portfolio of stocks and bonds should have no problem doubling at least once every decade (if not more frequently).
It’s like they say, “time is money.”
Kids have more of it than any of us.
Availability of Contributions
Another feature is the availability of contributions.
I never really love pointing this out because Roth contributions are so valuable and cannot be replaced.
However, I also remember entering adulthood with a negative net worth and the sudden need for cash to pay for a place to live, a car to drive to work in, and well, food to eat.
It’s tough to get going early in life.
Having the option to grab Roth contributions could be particularly helpful for avoiding debt that perniciously ensnares so many of us in those formidable financial years.
Speaking of avoiding debt, up to $10,000 of Roth IRA earnings can be used in a first-time home purchase, tax and penalty-free.
Roth earnings can also be used to pay for tuition, but those withdrawals are subject to income tax.
Practically Assured Tax Optimization
Finally, contributing to a custodial Roth IRA ensures that the money going into the account is being contributed in an optimally tax-efficient manner.
Many a debate has raged over the superiority of Roth or Traditional IRA and/or 401(k) contributions, but for a minor with low income, this becomes a bit of a moot point because their income tax level is probably as low as it will ever be.
You or your child can contribute to this account knowing that the money going into it will be liberated from taxes forever.
It’s hard to overstate the value of that.
Conclusion
Custodial Roths are a no-brainer if your child has earned income and the financial ability to contribute.
There aren’t many places to get tax-free earnings from an investment and to achieve it with such a long horizon before withdrawal is particularly valuable.
Not all brokerages offer an option for Custodial Roth IRAs, but most do. You’ll need your kid’s social security number, birth date, and about 20 minutes to set it up online.
Be sure to pay attention to fees as you set these up. Most accounts are free, but some do charge a fee (which I would avoid if possible).
With that said, I want to reiterate my point earlier about not being too creative for the sake of getting contributions into an account for your kids. It’s just not worth it.
