We want our kids to be smart, have a strong work ethic, and forge their financial future with confidence and savviness. That’s why, in our last article, we highlighted the importance of fostering good financial habits from day one through allowances systems, budgeting, and even basic investing principles. In this article, we’re going to dive a bit deeper: helping your child get started with tax-friendly investing as early as possible with the assistance of a Custodial Roth IRA.
A Custodial Roth IRA is nearly identical to its counterpart, the Roth IRA. The key difference here is that a Custodial Roth IRA is only for children with earned income and is technically a beneficiary of the IRA, not the owner, until they reach the age of majority, which is either 18 or 21, depending on your state. Until then, the custodian manages the assets and funds within the account, meaning that the custodian is also responsible for choosing the funds within and rebalancing as necessary.
Who Can Fund a Custodial Roth IRA?
To contribute to a Custodial Roth IRA, your child must have earned income from a job or self-employment. This includes traditional jobs like part-time work or gigs like babysitting and lawn mowing. The maximum annual contribution is the lesser of your child’s total earned income, or $7,000 (for 2024).
As the custodian, you can contribute your own funds to the account on their behalf, but the total annual contributions cannot exceed your child’s earned income for the year or the IRS contribution limit, whichever is less.
Typically, a child doesn’t start working until their teenage years, which gives them a few years advantage over someone just starting a Roth account after college or once they enter the workforce as an adult.
However, if you’re a small business owner, you can possibly hire your child at a much younger age, which would then qualify them to contribute to a Custodial Roth IRA. You can then decide to fund the Custodial Roth IRA for them, giving them the benefit of both their earnings and retirement contributions. The younger they are, the greater of an impact it will have on their potential long-term financial success.
Keep in mind that the work your child performs must be real, and they must be paid by industry standards. No, you can’t pay your child $1,000 to watch the paint dry at your office!
The Power of Time and Compound Gains
But let’s imagine that you do manage to hire your child early on from a young age and manage to contribute, say, $1,000 a year between the ages of 5 and 18. From there on out, they don’t contribute anything else, but the account maintains an average rate of growth of 10%.
Assuming an average annual growth rate of 10%, which is not guaranteed and may vary, they could accumulate approximately $2,300,000 by age 65. That’s without additional contributions after reaching 18. However, it assumes a growth rate of 10% per year, which is often lower as one typically shifts to more conservative investments nearing retirement.
While historically, some investments have averaged around 10% growth annually, it’s important to note that all investments carry risk, and returns can vary.
The point still stands, though – you could potentially single-handily fund your child’s retirement with a mere $13,000. Keep in mind that inflation and changes in the cost of living can affect the future purchasing power of this amount.
If your child needs money earlier than that, there won’t be any early withdrawal penalties on contributions, plus they can withdraw up to $10,000 worth of earnings for the purchase of a first home without a penalty.
Considerations Before Opening an Account
Control Upon Reaching Adulthood: Once your child reaches the age of majority, they gain full control over the account. There will be little you can do to prevent them from withdrawing and spending their savings how they please.
Impact on Financial Aid: While the assets in a Custodial Roth IRA are not reported as assets on the FAFSA, distributions from the account can be considered income and may affect eligibility for need-based financial aid.
Contribution Limits: Contributions cannot exceed the child’s earned income for the year, so if they earn $3,000, that’s the maximum they can contribute, even if the IRS allows for higher contribution limits for adults.
Other Accounts to Help Your Child Save for the Future
If you’d like to begin saving for the future of your child from a young age, you’re not restricted to putting them to work and contributing to a Custodial Roth IRA. For college, you can utilize a 529 College Savings Plan, which allows you to save for college tuition and other qualified expenses in a tax-advantaged manner while also reducing your taxable estate.
For more general investment goals, you might consider either a UGMA (Uniform Gifts to Minors Act) account or a UTMA (Uniform Transfers to Minors Act) custodial brokerage account. Both accounts allow you to transfer assets to your child, and once they reach the age of majority, they gain full control of the assets. The main difference is that a UGMA is limited to financial assets like stocks and cash, while a UTMA can hold a wider range of assets, including real estate and other property. Both accounts offer a flexible way to save for your child’s future without the restrictions tied to retirement or education-specific savings.
Contributions to UGMA and UTMA accounts can also help reduce your taxable estate. Contributions are considered completed gifts under the IRS gift tax rules, and in 2024, you can contribute up to $18,000 per year per beneficiary without incurring gift taxes, and if you’re married, you and your spouse can contribute up to $36,000 for the year.
Final Thoughts
As students head back to school this September, it’s an ideal time to focus on their future—not just academically but financially as well. Starting young will not just help instill strong financial habits but also help set them up for financial success years into the future. If you’re interested in exploring how a Custodial Roth IRA or any other kind of investment account designed to benefit children can fit into your family’s financial or estate plan, click the button below to arrange a consultation.
