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A Roth IRA is one of the best ways to save for retirement. Common knowledge suggests that the account’s primary purpose (retirement) means it is only suitable for adults who have retirement in sight. Think again.

Yes, a Roth IRA is a great avenue for adults to save for retirement. However, it is also an incredibly powerful tool for children because their tax burden is as low as it will ever be, and it sets the stage for sound financial management into the future.

What Types of IRAs Can You Open for a Child?

The two main types of IRAs that you can open for your child are the Roth IRA and the Traditional IRA.

Traditional IRA

A traditional IRA is funded with pre-tax dollars. The contributions and earnings are tax-deferred, meaning all withdrawals are taxed at the individual’s marginal tax rate at the time of withdrawal. A tax-deferred retirement account is ideal for someone who believes their tax rate will be lower in retirement than it is at funding.

Roth IRA

Unlike a traditional IRA, you fund a Roth IRA with post-tax dollars. Since you’ve already paid taxes on the income that funds the account, your contributions are tax-free, and if you follow the requirements, all earnings and qualified withdrawals can be tax-free as well. As a result, the Roth IRA is ideal for investors who believe they are in a lower tax bracket when funding the account than they will be at the time of withdrawal.

Traditional vs. Roth IRA: Which is Better for My Child?

Children tend to have little taxable income and are therefore in the lowest of tax brackets. In fact, they may not even be required to file a return and report their income. 

Because you fund a Roth IRA with after-tax dollars, it is almost always the best option for children with income.

Since your child will likely be in a low tax bracket now and will likely be in a higher tax bracket when they withdraw funds at retirement, the Roth IRA provides an amazing opportunity to jumpstart savings in a tax-efficient manner.

How to Open a Roth IRA for Kids

Opening a Roth IRA for your child can be done by you, with or without your child. However, since the individual opening the account must be 18 or older, you’ll need to lend a hand to establish their account.

Because your child is not old enough to open the account solely in their name, the account that you open will be a custodial Roth IRA. This can sometimes also be known as a guardian Roth IRA. You will open the account in your child’s name by providing their information, such as their legal name, address, social security number, and date of birth.

As the custodian, you will be responsible for controlling the assets within your child’s Roth IRA. You will make decisions such as choosing individual investments, naming beneficiaries, and the like.

Can Parents Contribute to a Roth IRA For a Child?

Yes! Parents can contribute to a Roth IRA for a child. The parent will need to ensure that their contribution does not exceed the lesser of:

  • A) the child’s earned income for the year OR 
  • B) the annual contribution limit of $6,000 for 2021/2022.

Can Grandparents Gift a Roth IRA to Their Grandchild?

Absolutely. Just as with contributions to a child’s Roth IRA from a parent, the contribution cannot exceed the lesser of A) their earned income for the year or B) the annual contribution limit of $6,000 for 2022.

The grandparent can take three different approaches to gift a Roth IRA to their grandchild:

  1. Establish a custodial Roth IRA account for their grandchild and fund it directly;
  2. Gift the child the money to contribute to an already established Roth IRA in the grandchild’s name;
  3. Name the grandchild child as the beneficiary of a Roth IRA that already exists in the grandparent’s name.

How to Fund a Roth IRA for Kids

Funding a Roth IRA for kids is easy. Once you’ve established the account, you will be able to transfer funds from your funding account (usually a personal checking or savings account) to the brokerage that manages the Roth IRA. From there, you can choose the investments you’d like to invest the funds in or add to an existing investment.

Investment Strategies to Consider

We’ll always suggest speaking with a Financial Advisor to determine your investment strategy. However, low-cost index funds are an excellent choice when investing the funds within a Roth IRA for kids. These funds track the broad markets while keeping fees low to allow your child to accumulate more money in your Roth IRA.

Your child has a long investment period ahead of them. A simple investing strategy will also allow you to teach your child about investing more easily.

Other Rules of Roth IRAs for Children

The rules of Roth IRAs for kids will mimic those of Roth IRAs for adults. The IRS does not pay any mind to the account owner’s age; the primary requirement is that the account owner has earned income and does not over-contribute.

For 2021 and 2022, the maximum contribution to an IRA is $6,000. One exception is individuals over 50, as their limit is $7,000 for catch-up contributions.

The only other requirement is that the child earned income during the tax year they contribute to their Roth IRA.

If the child has earned less than $6,000, they can only contribute up to the amount they’ve earned. However, if they have earned over $6,000, they can contribute the full limit of $6,000.

What Age Can You Start a Roth IRA?

It makes sense to wonder at what age you can start a Roth IRA. Given that this is a retirement account, you would expect some sort of minimum age for a Roth IRA.

Currently, the IRS has no minimum age limits for IRA contributions. The requirement, instead, is that the individual must have earned income in the same year that they make the contributions to the account.

Earned income for children can be a tricky subject, so let’s break it down.

Traditional thinking of earned income for kids would suggest that the child must have a W2 job, like washing dishes, working at a community center, or a movie theatre. After all, these are the places we tend to see teenagers working.

While these are absolutely valid sources of income for children that will allow them to contribute to a Roth IRA, they aren’t the only options.

Many children have other sources of income. If your child has any source of earned income that they want to contribute to a ROTH IRA for kids, you can work with them and your tax professional to find the best possible way to do so in a tax-advantaged manner.

Qualifyed Earned Income for a Roth IRA for Kids

Let’s dive into the earned income component, as that can be a bit tricky.

For a child’s earnings to be considered “qualified,” they must be able to show their income. Income can come from a W2 job, self-employment such as dog walking or lawn mowing, or 1099 contract work. Keep in mind that the IRS does not consider investment income to be earned income.

To qualify, the child must earn their income in the tax year they make contributions. It does not matter what the child does with their money. They don’t need to put those specific dollars into their IRA. They just need to have earned as much money (or more) as is being contributed to their Roth IRA by them or on their behalf. 

Depending on your situation, your child may earn income in many ways. For small business owners, there are opportunities to bring their children into the fray of their work.

Even the youngest of children can earn an income!

Suppose you have a social media or digital marketing campaign for your business. In that case, you might consider hiring your child to perform as a model rather than paying for stock images of unknown people from an unknown website.

If your child wants to earn income to fund their Roth IRA, they can do side jobs for neighbors, such as yard work or helping with household tasks. There doesn’t necessarily need to be a traditional paper trail like a W2 or 1099, but encourage your child to create invoices and keep receipts. Not only will this further justify the income in the event of questions from the IRS, but it also teaches money management and business skills.

Ways Children can Earn Money to Fund a Roth IRA for Kids

If you have children who aren’t old enough to get a job or simply don’t have one, here are a few ideas to share with them to get them started.

  • Cleaning yards, houses, or even pets
  • Washing cars for neighbors
  • Pet sitting for neighbors when they go out of town
  • Pooper-scooper lawn service
  • Cleaning driveways, garages, and sidewalks
  • Mowing lawns
  • Providing child care for friends and neighbors
  • Washing windows
  • Earning money by selling items (i.e., old toys still in good condition) online or at garage sales

Roth IRA Income Documentation for Kids

Once your child has earned money, it is good to encourage some sort of documentation and even deposit those funds into a bank account. Again, the IRS does not require documentation of the earned income to fund the Roth IRA. However, if they choose to inquire, it will be best to have some documentation to verify the earned income.

A simple ledger in a notebook may be sufficient, but the custodian should oversee the process and keep it with their own records as they are responsible. Other ideas are to have a Google Sheet or Doc. 

Whatever method you and your child use, be sure to include the date, time, customer’s name, job, and the child’s earnings for the job. Bonus points for getting the customer to sign off on an invoice and providing them with a receipt!

Gifted contributions

If funds are being gifted to the child by a parent or grandparent, there is a maximum annual amount that an individual can gift without tax implications. The limit for tax-free giving in 2021 is $15,000, which will increase to $16,000 in 2022.

Also, annual contributions to a Roth IRA are limited to $6,000 per individual account owner. The annual contribution limit is the same regardless of how many Roth IRA’s your child may have (you can have multiple, although it is not overly beneficial) or how many people are choosing to contribute to that child’s Roth IRA.

Communication is key if you intend to encourage family members to contribute to a custodial Roth IRA for your child. You must ensure that:

  • A) the child has earned enough income to support the contributions and 
  • B) no more than $6,000 is contributed to the account.

What are the Benefits of a Roth IRA for Kids?

We all wish we had started investing ten years earlier. By establishing a Roth IRA for your child, you give them that gift. However, the benefits go well beyond the simple investment.

Contributions can be withdrawn at any time without penalty.

However, withdrawals of earnings will be taxed as income and penalized with a 10% fee if the funds do not meet the qualifications.

The IRS defines a qualified distribution from a Roth IRA as a payment or distribution that is made after the 5-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for your benefit OR if the distribution is made:

  • on or after the date you reach age 59½,
  • due to a disability,
  • to a beneficiary or your estate after you pass, or
  • under the First Home exemption, which we’ll explain in more detail soon.

What’s important to note is that this “penalty” only applies to earnings, not contributions. You have already paid taxes on your contributions, as this is a Roth IRA, not a Traditional IRA. Because contributions were already taxed, you can withdraw contributed funds without penalty or taxation at any time for any reason.

The earlier you start, the more time there is for growth

Compound interest is a powerful force. Just a few years of extra time can have an exponential impact on your child’s future.

Since there is no minimum age for a Roth IRA, we can illustrate this by comparing what will happen if your child starts contributing $3,000 per year to a Roth IRA at age ten vs. age fifteen.

We’re going to assume a hypothetical annual return of 7%. So we’ll ultimately be looking at a 5-year difference in investment growth.

Investing $3,000 per year into a custodial Roth IRA for your child beginning at age ten will result in a balance of approximately $32,934 at age 18.

That same investment with the same rate of return beginning at age 15 will reduce the total balance to approximately $10,320.

The difference in contributions was about $15,000, but the difference between the two accounts was nearly $23,000.

As a fun exercise, let’s forward that to a typical retirement age. We’re going to use all the same numbers, except we will assume your child has heeded your advice and continued to contribute $3,000 to their Roth IRA each year.

At age 63, your investor who began at age ten will have accumulated $1,609,000. The child who began investing at 15 will have accumulated about $1,134,000. The five additional years in the market amount to nearly $500,000 when compounded over such a long time.

Investing is better than saving

A smart parent teaches their child to save.

A wise parent teaches their child to invest.

By opening a Roth IRA for your child, you are not only allowing them to start learning about finances. You are also showing them how to gain control over their money.

While there is no guarantee of future results, the earlier they start, the better the chance that your child will achieve financial independence.

Better tax advantages for kids

Here’s where a Roth IRA for children packs the most punch.

Children who earn income do not typically earn a significant amount. Yes, there are outliers, but we’ll assume that’s not your child for this conversation. An ambitious school-age child may hustle to earn a few thousand dollars a year. A child earning $6,000 (the maximum contribution amount of a Roth IRA) may not even have to file a tax return. If they do, their tax burden is likely to be significantly less than someone employed full-time.

Since you’ll fund a Roth IRA with after-tax dollars, grows tax-free and qualified distributions are received tax-free, there is a triple-tax advantage to a Roth IRA for children.

Financial Literacy

This benefit of a Roth IRA for kids may be more valuable than the IRA itself.

Children who learn about Roth IRAs and the benefits of investing early will be more likely to gain invaluable financial literacy lessons along the way.

With Roth IRAs for kids, a younger child can easily “see” that money saved today is worth a lot more than the same amount saved a year from now or five years from now.

Their Roth IRA will be a visual demonstration of the power of compounding and time over money.

By opening a Roth IRA for your child, you are laying the foundation that could ultimately help them become financially independent sooner.

Roth IRAs for kids can be a great way to teach children about financial responsibility while helping them invest for their future.

Business Skills

Another intrinsic benefit of this process is helping your child understand the value of work and creative ways even kids can earn an income. By earning income through age-appropriate work, your child is learning about business.

The Roth IRA for children process opens the door to start teaching them about the benefits of investing, the immeasurable value of a dollar earned, and —if you choose to match their earnings—how to use an employer’s incentives to their benefit.

Uses Beyond Retirement

One lesser-known benefit of Roth IRAs (for kids or otherwise) is that your child can use the account for more than just retirement.

Yes, their primary purpose is to serve as an investment vehicle for retirement. However, several exceptions exist that are helpful to be aware of, especially when considering the custodial Roth IRA for a child.

Educational Expenses

The penalty does not apply to distributions used for educational expenses, so long as the expenses are qualified under IRS rules. This exemption can raise the idea of using a Roth IRA instead of a 529 Plan for college savings. This becomes a complex topic that is very situational but worth consideration. 

Medical Insurance and Expenses

Another exception exists if you have lost your job and incur medical insurance or medical expenses for yourself, your spouse, or any dependents that you claim. There are several conditions the IRS requires to be met to avoid the 10% additional tax.

Buying a House

Roth IRA owners can withdraw up to $10,000 in earnings to buy a first home. Keep in mind that this is per Roth IRA account and not per Roth IRA owner. If you (or your child) and a spouse both have Roth IRAs (imagine both sets of parents being so proactive!), they are both able to withdraw up to $10,000 to fund the purchase of their first home.

Emergencies

In the event of a qualified disaster, some benefits may apply that eliminate the penalties of taking distributions from a Roth IRA to recover. As we saw after Hurricane Katrina and during the Covid-19 pandemic, the IRS tends to announce disaster-related relief after the named disaster. 

Specific benefits and eligibility requirements usually vary depending on the nature of the disaster, but it helps to know that access has been made easier during troubling times.

Final Thoughts

The ability to begin investing early and benefit from compounding interest will provide your child with a strong head start on their financial future. A Roth IRA for children can serve as a long-term investment account, impart financial literacy, help with future educational expenses or buy a home down the road.

For more information about Roth ira accounts for kids, speak with an advisor at Dechtman Wealth Management today.


Dechtman Wealth Management, LLC is a Registered Investment Adviser. This is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Dechtman Wealth Management, LLC and its representatives are properly licensed or exempt from licensure.  Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Dechtman Wealth Management, LLC unless a client service agreement is in place. 

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