Contributing to a Roth Individual Retirement Account (IRA) is an extremely efficient way to save for retirement. The sooner you start contributing, the greater the opportunity for your savings to accumulate tax-free over time.
Wouldn’t it be great if your children could take advantage of a Roth IRA and start saving in their teenage years? Good news! They can. Your child may be eligible to open a minor-owned Roth IRA to start saving for retirement, as well as other future expenses.
Minors may also be eligible to open traditional and inherited IRAs, but here are focusing only on the benefits of a Roth IRA.
The registration process varies from provider to provider, but the account is typically opened as a custodial Roth IRA. The child is the account owner, with an adult serving as the custodian. Contributions are reported to the Internal Revenue Service (IRS) under the minor’s social security number, but the custodian completes the new account paperwork and is the individual authorized to act on the account. The custodian is usually (but not always) a parent. Providers may have additional requirements if someone other than a parent serves as the custodian.
There is no age requirement to make a Roth contribution—the same eligibility rules apply to both adults and minors. Once the child reaches the age of majority (either 18 or 21 depending on the state), the funds can be transferred into a Roth IRA in the adult child’s name. Subsequently, the adult child is authorized to manage the account.
The minor must have earned income to make a Roth contribution. A child with a part-time job after school or summer employment is a prime candidate.
Ideally, your child’s employer will issue a W-2 for the work performed. But what if your child isn’t employed with a company but does neighborhood work, such as mowing lawns, shoveling snow, or babysitting? Is the money received considered earned income? The answer is, maybe. It’s up to you to document that your child received earned income and that the amount is reasonable.
For example, you could not pay your child $1,000 for two hours of babysitting. Consultation with a tax advisor or certified public accountant (CPA) is recommended if you’re unsure whether your child’s work can be substantiated as earned income and if the pay is reasonable.
The total amount minors can contribute for a year is $6,500 (for 2023) or 100 percent of their earned income, whichever is less. A commonly asked question is, must the contribution be made with the income earned by the child, or can it be funded with a gift from a parent or family member? Either option works. Keep in mind that the IRS imposes limits on tax-free gifts. If a minor-owned Roth IRA is funded as a gift, we recommend consulting a tax advisor to ensure that IRS gift tax rules are followed.
Five years after the first contribution is made to a Roth IRA, different options for withdrawing funds apply.
Once the child reaches age 59½, all funds in the Roth IRA can be withdrawn tax and penalty-free. For example, let’s assume your 15-year-old son or daughter makes a $6,000 contribution and never contributes again. Assuming a six percent rate of return compounded annually, that contribution will be worth $110,520 when the child is 65 years old. That beats a normal savings account earning minimal interest.
Please note: This scenario is hypothetical, and future rates of return can’t be predicted with certainty.
Your child can withdraw the earnings in the account tax and penalty-free to pay for costs associated with purchasing his or her first home. The amount not subject to tax and penalty is capped at $10,000. (Consult IRS Publication 590-B for details on what expenses are deemed qualified home acquisition costs).
Earnings may be withdrawn to pay for qualified education expenses, including college tuition, books, and supplies. Distributions of earnings will not be subject to the early withdrawal penalty but will be subject to ordinary income taxes (Consult IRS Publication 590-B for details on what expenses are deemed qualified education costs).
Account contributions can be withdrawn tax and penalty-free if needed for an emergency. In this case, the five-year waiting period after the account has been opened does not apply. The child’s contributions can be withdrawn at any time and at any age.
It’s unrealistic to expect children earning money to think about saving it for retirement rather than buying what they want now. However, providing them with a Roth IRA is a good way to instill the practice of setting money aside for the future. Plus, if you agree to match the funds they contribute, you’ll demonstrate the importance of putting money away for the long haul.
Overall, a minor-owned Roth IRA is a great way to teach your children the value of saving—and to get them started! We understand this can be a complex topic and we're here to help. Contact us today.
Michael Embrescia is a financial advisor located at EmVision Capital Advisors, 251 W. Garfield Rd. Suite 155 Aurora, OH 44202. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (330) 954-3770 or at info@emvisioncapital.com.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.