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.
- If it has been at least five years since the account was established (unless an exclusion applies), the contributions (not the earnings on them) can be withdrawn without penalty, and the withdrawals will not be taxed.
- In retirement, the contributions and the accumulated earnings can be withdrawn, and the withdrawals will not be taxed.
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.
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.
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.
Custodial Roth IRA Eligibility
Per the Internal Revenue Service (IRS), anyone with an 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 level increases.
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 in 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 to begin with. The important thing to remember is that their annual Roth IRA contribution cannot exceed their earned income.
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.
Contribution Limits
According to IRS guidelines for 2022, the annual contribution limit for a Roth IRA is $6,500 for people under age 50 and $7,500 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.
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, but the annual amount you can contribute cannot exceed either the beneficiary’s earned income or $6,500 — whichever is greater.
Distribution Guidelines
Per the IRS, a qualified Roth IRA distribution, also known as a withdrawal, is one that is made at least five years since the account was established and one that happens either on or after the day the account owner reaches age 59 1/2. 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 1/2.
Early withdrawal of earnings is permitted in certain circumstances and for certain expenses only, which may include, but is 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, whether your goals are for preserving capital, growth, income or a balance of growth and income.
While you have flexibility with some assets in a Roth IRA, the IRS specifically 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.
What Are the Benefits of Roth IRAs for Kids?
Roth IRAs have more advantages than disadvantages, and you can avoid the disadvantages for the most part 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 earnings can grow if you 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
- Offers a flexible way to save money with much more growth potential than standard savings accounts
- Provides a real-world avenue to facilitate financial awareness and education for kids
- Can house a wide variety of diverse assets, including stocks, bonds, alternative investments and cash
- Can be implemented in a low-cost, passive manner with minimal hands-on effort
- Tax-exemption allows for powerful effect of enhanced compound growth of earnings
- Contributions, but not the earnings on them, can be withdrawn penalty-free anytime as long as 5 years has passed since the IRA was established
- There are no IRS required minimum distributions, which can significantly enhance growth
Cons
- Annual contributions are limited to the lesser of $6,000 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 they retire, any withdrawals your child makes 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 the income tax rate that applies to your child at the time the withdrawals are made.
Which Is Better?
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 their working years or during their retirement years.
- 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 their 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 would be very limited.
