A Roth IRA will help your hard-working kid prepare for their future

Saving for retirement might not be top of mind for most kids, but financially savvy parents, grandparents or guardians can get the ball rolling by opening an IRA on their child’s behalf. As long as the minor has earned income for the year, a Roth IRA is a great option to start saving for their future.

Roth IRA for kids defined

A Roth IRA for kids is a type of custodial account, and you can open a custodial IRA for your child as soon as they have earned income. But since they’re a minor, you’ll need to open and manage the account on their behalf until they reach the age of majority. This is typically 18 or 21, depending on the state, but some states allow the transferor to stipulate that the recipient be 25 before taking over the account.

Contributions to a custodial IRA can be made using money the child has earned from their job or money you contribute on their behalf. Regardless, the total contribution limit is $6,000 or 100% of your child’s taxable income for the year, whichever is less.

Like regular Roth IRAs, contributions to Roth IRAs for kids aren’t tax-deductible. Contributions are made using money that has already been taxed. But as a result, any earnings and withdrawals made in retirement are tax-free.

Additionally, Roth IRA contributions can be taken out at any time and for any reason without taxes or penalties. Restrictions on withdrawals only apply to earnings.

3 advantages of a Roth IRA for kids

Here are a few reasons you should open a Roth IRA for your child.

1. Compounding interest

Compound interest is the money you earn on your investment as its value grows and you collect dividends or interest. As your savings grow, there’s a snowball effect, and you earn money on a bigger and bigger sum of money.

When you invest early in securities or assets, you have more time to potentially benefit from this compounding growth. A dividend is paid per share of stock, and when reinvested, you can reinvest those dividends to buy more company stock. On the next dividend payout, you’ll own more shares and, therefore, earn a higher dividend payment.

Value growth is easier to understand. If your $1,000 stock holding goes up 10% this year, you now have a $100 gain and an $1,100 stock holding. A 10% gain next year earns you $110.

2. Financial literacy

By helping your kid invest early, you’ll start them on a path to developing, understanding and effectively using various financial strategies.

Ensuring that your child is educated on the best way to manage money will help develop their financial literacy and secure their economic future.

3. Eligible expenses

Roth IRAs allow you to take out contributions at any time and for any reason. But distributions of earnings before your child reaches age 59 ½ and before the account is five years old are generally subject to taxes and penalties. In this case, earnings distributions would be taxed at your child’s tax rate at the time of the distribution and would incur a 10% early withdrawal penalty.

But your child may be able to avoid paying taxes on earnings and early withdrawal penalties if the money is used to pay eligible expenses, even if your child is under the age of 59 ½.

Roth IRA held less than five years

Your child may be able to avoid the 10% early withdrawal penalty, but not taxes, in the following situations:

• They use the withdrawal of up to $10,000 to pay for a first-time home purchase.
• They use the withdrawal to pay for qualified education expenses.
• They use the withdrawal for qualified expenses related to birth or adoption.
• They experience a disability or pass away.
• They use the withdrawal to pay for unreimbursed medical expenses or health insurance if they’re unemployed.
• The distribution is made in substantially equal periodic payments.

Roth IRA held more than five years

Your child may not have to pay taxes on qualified distributions, which are distributions that meet any of the following requirements:

1. The distribution is made five years after the contribution was made to the account.
2. The distribution is:

• Made on or after your child reaches the age of 59 ½.
• Made because your child has a disability.
• Made to a beneficiary after your child’s death.
• No more than $10,000 and used for a first-time home purchase.

Roth vs. traditional IRAs for kids

For young workers, Roth IRAs provide several benefits over traditional IRAs. But it’s still a good idea to compare Roth IRAs with traditional IRAs so that you settle on an account that allows your child to get the most out of their savings.

Since your kid is probably just getting started earning money, they’re likely in the lowest tax bracket and will pay a higher tax rate later in life. With a Roth IRA, distributions in retirement are tax-free regardless of the tax bracket. The future taxes your child would pay on distributions from a traditional IRA would likely be more significant than any tax break they’d get today on their contributions, making a Roth IRA the ideal choice.

Roth IRAs also allow savers to withdraw contributions penalty- and tax-free any time. In this way, a Roth IRA could act as an emergency fund of sorts as your child saves for retirement. The money is not locked in until retirement.

Traditional IRAs aren’t afforded the same flexibility. Additionally, Roth IRAs have no required minimum distributions (RMDs) after retirement. So your child can leave their money in their account for as long as they live.

3 steps to open a Roth IRA for kids

Most major brokers offer custodial IRAs. Depending on the broker you choose, you may be required to download and fill out a paper application to open an account, whereas others may allow you to open an account online in only a few minutes. Either way, here’s how to open a Roth IRA for kids.

1. Compare and choose a broker. Not all brokers are cut from the same cloth. They offer different features and charge different fees. As you’re shopping around, compare brokers by factors like fees and trading commissions, minimum deposit requirements and reputation.
2. Submit your application. Whether it’s a paper or online application, the information you need to provide is generally the same. To open a Roth IRA for your child, you’ll typically need to provide:

• Your and your child’s identifying information such as names, Social Security numbers and birth dates.
• Your contact information.
• Your employment information.
• Bank information to fund the account.

3. Pick investments. If your child is interested in helping you choose their investments, now would be a good time to get them involved. With many IRAs, you can choose from the following investments:

Double down on your allowances

If you’re one of the majority of parents that are giving your kids an allowance, you could look to help them invest those funds into an IRA.

Bottom line

Roth IRAs are great investment vehicles for working minors. While they don’t offer any tax deductions on contributions, your child will benefit from tax-free withdrawals when they retire.

Getting your child started investing with a Roth IRA at a young age will position them to benefit from years of tax-free growth. And since your kid can contribute and withdraw at any time for any reason, Roth IRAs make a great backup for emergencies while they save and plan for retirement.

Before you make any decisions, consider consulting your tax or investment advisor. And look through our guide to investing for kids.