What Is a Custodial Roth IRA?
A custodial Roth individual retirement account (IRA) is an investment vehicle established by a parent or other adult on behalf of a minor. By making contributions to a Roth IRA, kids can save for the future in a tax-advantaged manner. Note that the child must have earned income to be eligible for this type of account.
At a high level, the process of contributing to a custodial Roth IRA works as follows:
- Contributions are made with after-tax dollars, and no tax deductions are provided.
- The contributions are invested and allowed to grow free of tax, which can have a powerful compounding effect over the long term.
- Contributions (not the earnings on them) can be withdrawn without penalty, and the withdrawals will not be taxed (as long as the account has been open for at least five years).
- If it has been at least five years since the account was established and you are at least 59.5 years old, the contributions and the accumulated earnings can be withdrawn, and the withdrawals will not be taxed.
A custodial IRA for a child provides two priceless benefits. First, there are more years available for contributions, and second, more time for even small contributions to begin to compound and grow. Seeding an investment account for a child will start slowly but begin to take off as they reach adulthood.
Stephen Kates, CFP®Founder of Clocktower Financial ConsultingStephen Kates is a Certified Financial Planner™ and personal finance expert specializing in financial planning and education. Stephen has expertise in wealth management, personal finance, investing and retirement planning.
How Can I Start a Custodial Roth IRA for My Child?
You can open a custodial Roth IRA for a minor through a major brokerage firm such as Charles Schwab, E-Trade or Fidelity Investments. A financial advisor can help guide you through the process, or if you don’t have an advisor, you can work directly with the brokerage firm. All you need to have on hand is some key identifying information about yourself and the minor.
How To Open a Custodial Roth IRA in 5 Steps:
- Ensure your child has earned income.
- Select a broker.
- Open and fund the account.
- Invest using your contributions.
- Connect a bank account to make regular contributions.
When you open the custodial Roth IRA account, you become its legal custodian, and the minor is named as its beneficiary. These designations will remain in force until the beneficiary reaches the age of adulthood in your state (usually, 18 or 21 years old). At that point, the account is completely transferred over to the beneficiary.
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Custodial Roth IRA Eligibility
Per the Internal Revenue Service (IRS), anyone with earned income, including kids, can contribute to a Roth IRA and reap the benefits of tax-exempt growth of their earnings. However, the amount that beneficiaries or account holders can contribute is reduced or eliminated as income increases.
In 2023, the maximum your child can contribute to an IRA is the lesser of $6,500 or his or her taxable earnings for the year. For example, if your kid makes $1,000 for the year with a dog-walking business, the most he or she can contribute to the IRA is $1,000.
To be eligible for a custodial IRA, a child has to earn income and pay taxes on it. The income can be earned by working for a company or by providing services, such as mowing lawns and babysitting.
For a custodial Roth IRA, the phase-out levels are based on the beneficiary’s modified adjusted gross income (MAGI), which takes their adjusted gross income and adds back a handful of exclusions and deductions such as tax-exempt interest income and student loan interest expenses. For 2023, the IRS limits for single tax filers can be summarized as follows:
A full Roth IRA contribution is allowed when your MAGI is less than $138,000. You can make a partial contribution if your MAGI is $138,000 or more, but less than $153,000. If your MAGI is $153,000 or more, no contribution is permitted.
Most minors aren’t impacted by the Roth IRA contribution phase-outs because they don’t make much income. The important thing to remember is that their annual Roth IRA contribution cannot exceed earned income.
Custodial Roth IRA Contribution Limits
According to IRS guidelines for 2023, the annual contribution limit for a Roth IRA is $6,500 for people under the age of 50. An additional $1,000 catch-up contribution is permitted for people aged 50 and over. It’s important to remember that this is an aggregate limit that applies to all of your IRAs. You can continue making regular contributions to a Roth IRA no matter your age, but all contributions must come from earned income.
While a custodial Roth IRA allows for the penalty-free withdrawal of contributions before retirement age, any money put into the account should be left to grow as long as possible to maximize the tax advantages.
Incidentally, contributions to a custodial Roth IRA can be made by people other than the beneficiary. If you are the account custodian, you can make contributions on behalf of the beneficiary. However, the annual amount you can contribute cannot exceed the lesser of the beneficiary’s earned income or $6,500.
2023 Roth IRA Contribution Limits
| FILING STATUS | MAGI | CONTRIBUTION LIMIT |
| Married filing jointly or qualifying widow or widower | Less than $218,000 | Up to age 50, $6,500, 50 and older, $1,000 |
| Married filing jointly or qualifying widow or widower | $218,000 to $228,000 | A reduced amount |
| Married filing jointly or qualifying widow or widower | More than $228,000 | $0 |
| Married filing separately | Less than $10,000 | A reduced amount |
| Married filing separately | $10,000 or more | $0 |
| Single, head of household or married filing separately and did not live with you spouse any time during the year | Less than $138,000 | Up to age 50, $6,500, 50 and older, $1,000 |
| Single, head of household or married filing separately and did not live with you spouse any time during the year | $138,000 up to $153,000 | A reduced amount |
| Single, head of household or married filing separately and did not live with you spouse any time during the year | $153,000 or more | $0 |
Source: U.S. Internal Revenue Service
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How Do Custodial Roth IRAs Work?
Aside from the unique process of setting up the account, a custodial Roth IRA works the same way as a standard Roth IRA. Let’s discuss the contributions limits, distribution guidelines and investment options for Roth IRAs.
Distribution Guidelines
Per the IRS, a qualified Roth IRA distribution (also known as a withdrawal) is one that is made at least five years after the account was established and on or after the day the account holder reaches age 59 ½. If these conditions are met, all withdrawals are exempt from income tax.
If these conditions are not met, a 10% federal tax penalty could apply, and any earnings withdrawn could also be subject to taxation. The financial penalties are highest for those who take money out before age 59 ½.
Early withdrawal of earnings is permitted in certain circumstances and for certain expenses, which may include, but are not limited to, the first-time purchase of a home, medical bills and higher-education expenses.
Investment Options
Roth IRAs can hold a wide variety of assets, including stocks, bonds, alternative investments, cash and fund-style vehicles that contain various combinations of assets. As a result, you can implement a Roth IRA to achieve virtually any investment objective, such as preserving capital, growing your assets and/or generating income.
While you have extensive flexibility with regard to holding assets in a Roth IRA, the IRS prohibits investments in life insurance contracts, collectibles and certain derivative instruments. Further, if you want to put gold or cryptocurrency inside a Roth IRA, you’ll have to open an account specifically designed to house those assets.
Read More: Roth IRA Calculator
Pros and Cons of Roth IRAs for Kids
Roth IRAs have more advantages than disadvantages, and you can largely avoid the disadvantages through careful planning and financial discipline. For kids, the advantages of a Roth IRA are even greater than they are for adults. Given kids’ long investment horizons, they are uniquely positioned to fully capitalize on decades of tax-exempt, compound growth. With the Roth IRA calculator, you can get an idea of how much your child’s earnings can grow, if they start making contributions at a young age.
The table below offers a fairly comprehensive outline of the pros and cons associated with custodial Roth IRAs.
Pros
- Roth IRAs offer a flexible way to save money with much more growth potential than standard savings accounts.
- Contributions can be used for more than retirement — such as putting $10,000 towards buying a house or paying for education costs.
- They provide a real-world avenue to facilitate financial awareness and education for kids.
- They can house a wide variety of diverse assets, including stocks, bonds, alternative investments and cash.
- Roth IRAs can be implemented in a low-cost, passive manner with minimal hands-on effort.
- Tax exemption allows for the powerful effect of enhanced compound growth of earnings.
- Contributions, but not the earnings on them, can be withdrawn penalty-free anytime (as long as the account has been open at least five years).
- There are no IRS-required minimum distributions, which can significantly enhance growth.
Cons
- Annual contributions are limited to the lesser of $6,500 or earned income
- No tax deductions are available; all contributions are made with after-tax dollars
- Generally, a 10% penalty applies for distributions of earnings taken prior to age 59 1/2
Read More: Best Savings Accounts for Kids and Teens in 2023
Are There Other Ways I Can Start an IRA for My Child?
In addition to a Roth IRA structure, custodial IRAs are available in a traditional structure. As discussed previously, a Roth-style vehicle has no upfront tax deductions for contributions made by your child. Contributions are invested and grow during your child’s working years. Later, when he or she retires, any withdrawals will be free from taxation.
Conversely, with a traditional vehicle, contributions are generally tax-deductible in the year they are made. The contributions are invested and grow during your child’s working years. Then, in retirement, withdrawals are taxed at his or her prevailing income tax rate.
Custodial Roth IRA vs. Traditional IRA
When assessing whether it makes more sense to establish a custodial Roth IRA or a traditional IRA on behalf of a minor, the most important consideration is whether you expect the beneficiary to be in a higher tax bracket during his or her working years or retirement years.
- According to the Consumer Financial Protection Bureau, a Roth IRA is superior when the child, or beneficiary, is expected to be in a higher bracket in retirement.
- A traditional IRA is superior when the beneficiary is expected to be in a higher bracket during his or her working years.
Based on this rule of thumb, it’s hard to justify choosing a traditional IRA over a Roth IRA for a minor. Most kids earn only a small amount of money and face low income tax rates, so the economic value of tax deductions on contributions to a traditional IRA are typically very limited.
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Custodial Roth IRA FAQs
You and your child can only contribute money into a custodial Roth IRA up to the lesser of $6,500 of the amount of the child’s taxable income for the year. This means that if the child made $500 mowing yards — and paid taxes on it — you and the child can only contribute up to $500.
A Roth IRA can only be owned by one person. So you cannot open a Roth IRA with your child, and anyone under the age of 18 cannot open a brokerage in their own name. A custodial Roth IRA solves the problem by allowing a parent or grandparent to open the account. The IRA belongs to the child, while the adult serves as the custodian.
The amount a minor can contribute to a custodial Roth IRA is set by the IRS and typically changes each year. In 2023, a child can contribute up to $6,500 or the amount of taxable income earned in the year, whichever is less.
