Benefits of a Custodial Roth IRA for Your Kids

While children can’t open investment accounts on their own, they can earn money. Arguably, one of the best vehicles to use to sock away those earnings is a Custodial Roth IRA. Since children are minors, they need an adult (the “custodian”) as the other owner on the account with them. When they turn the age of majority, the adult can be taken off the account. The Custodial Roth IRA is a retirement savings account that can offer several benefits for your kids’ financial future.

Tax-Free Growth

The only type of contributions made to a Roth IRA are made with after-tax dollars. Those contributions then grow tax-free and are tax-free when taken out in retirement. Given that your children have many years ahead for the investments to compound and grow without being subject to annual taxes, time is on their side.

Potential for Long-Term Growth

Opening and funding a Custodial Roth IRA early for your children allows them to take advantage of the power of compounding returns over a longer period. The greater the time the funds stay invested, the greater the potential for wealth accumulation.

Retirement Savings Head Start

A Custodial Roth IRA allows your children to begin saving for retirement at an early age. Front loading retirement savings can give them a significant advantage by allowing them to save smaller amounts during years where cash flow might be tighter, while still accumulating a substantial retirement nest egg.

Financial Education and Responsibility

This is a perfect opportunity to introduce your children to the concept of investing and personal finance at a young age. Doing this when they are young can help foster financial literacy and responsibility. Engaging your child in the management and operation of a Custodial Roth IRA can provide valuable lessons about saving, investing, and long-term financial planning.

Flexibility and Withdrawal Options

Unlike contributions to a traditional 401(k) plan, the contributions made to a Roth IRA may be withdrawn at any time, tax-free and penalty-free. While this isn’t the intention for the funds, knowing the flexibility is available is convenient if your children need the money for qualified expenses such as education, a first home purchase, or other financial goals.

Rolling Over Excess 529 Funds

The SECURE Act 2.0 has a provision going into effect beginning January 1, 2024. Qualified “leftover” 529 account funds may be transferred to a Roth IRA free of any tax, penalty, or applicable income limits. There are a few catches and requirements. The biggest being that the Roth IRA needs to be maintained for at least 15 years. That is why opening a Custodial Roth IRA while your child is young helps get the clock started.

There are annual contribution limits to a Custodial Roth IRA which are the same as a regular Roth IRA. In 2023, this amount is $6,500. To fund a Custodial Roth IRA your child must have earned income. Please note that is legitimate earned income. Parents who may own a business and think they can payroll their children $6,500 just to turn around and then make a $6,500 Custodial Roth IRA contribution really need to make sure that the child is legitimately performing business activities to earn that $6,500. Don’t set yourself up for an IRS audit. Talk to your CPA or financial advisor to determine if this strategy is appropriate for your family’s situation.

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