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Updated on Friday, January 4, 2019
When you’re raising kids, it’s hard to picture them as adults, much less as retirees. So, setting up a retirement account for them isn’t always at the top of the list — or on the list at all — for parents who are focused on paying day-to-day expenses and saving for college. However, a Roth individual retirement account (IRA), can be a great investment tool for your child’s future, and it may help pay for some college costs.
Opening a Roth IRA for minors
Many people aren’t aware they can open an IRA for their children. Roth IRAs for minors can be opened in a child’s name, with an adult serving as custodian of the account until the child is of legal age. Here are five good reasons to consider opening a Roth IRA for your child.
1. No withdrawal restrictions on contributions
While the funds you contribute to a Roth IRA are maximized if they’re left to grow until the child reaches retirement age, they can be withdrawn at any time without penalty. There may be penalties for withdrawals of earnings on those funds if they don’t meet certain conditions (see below), but 100% of your contributions can be withdrawn at any time.
2. Compound interest
Compound interest is a powerful thing. The earlier funds are invested, the more years they have to grow, which is why Roth IRAs can be such effective savings tools for young people who have many years between now and retirement.
3. Tax advantages
All contributions to a Roth IRA are made with after-tax dollars. When your child is ready to withdraw the funds, they don’t have to pay any taxes, no matter how much the funds have grown over the years or what tax bracket they’re in when they withdraw the funds (as long as they meet certain qualifications).
4. Flexible use of funds
While some savings tools, such as 529 plans, restrict what you can use the funds for, the guidelines for Roth IRAs are more flexible. In general, you must be at least 59 and a half years old and the account must be at least five years old in order to receive 100% penalty-free withdrawals. However, there are a number of exceptions, including if the funds are used for education, health care expenses or a first-time home purchase.
5. Investing brings better returns than saving
The potential payoff with a Roth IRA is much greater than with a traditional savings account. A Roth IRA lets you invest your contributions in a variety of options — such as mutual funds, stocks, bonds, exchange-traded funds (ETFs) and FDIC-insured certificates of deposit (CDs) — with a much larger potential payout.
3 rules to know about your child’s Roth IRA
1. The child must have income
To open a Roth IRA for a minor, they must have some “employment compensation”; however, that doesn’t mean they need to bring home an actual paycheck. Money earned from doing chores around the house or babysitting is treated as compensation. While the Fair Labor Standards Act (FLSA) dictates 14 as the minimum age for employment, there are exceptions to the rule so younger children can receive compensation.
In some cases, self-employment taxes may be applied to these earnings, so it’s a good idea to consult with a tax expert to cover your bases.
2. There’s no age limit
There’s no age limit for Roth IRAs. However, if a child isn’t of legal age (usually 18 or 21, depending on the state in which you live), the account must be opened by a parent or an adult who serves as custodian of the account and is responsible for making account decisions. The account can be transferred to the child once they reach legal age.
3. There are contribution limits
How much your child can contribute to a Roth IRA depends on how much your child earns, as their contributions (or those gifted to them by a parent or other adult) can’t be greater than that amount. The maximum contribution for 2021 is $6,000 per year.
How to open a Roth IRA for your child
You can open a Roth IRA for a minor through an online broker, a bank or financial institution, a life insurance company, or a stock broker. You’ll need to provide certain documents and information, such as Social Security numbers, birth dates and other identifying information for you and the child, as well as any employment information. You’ll also need to supply the account and routing numbers of the accounts from which you plan to make contributions.
You’ll be ready to select your investments once you choose a plan. There’s no minimum fund requirement for opening a Roth IRA, although specific investments within the IRA — such as mutual funds — may have minimum requirements.
Alternative ways to save for your child’s future
If a Roth IRA doesn’t sound like a good option for your family, there are other options worth considering:
- 529 plans: These savings plans offer tax advantages and are designed specifically for education expenses.
- Coverdell education savings accounts: Similar to 529 plans, these accounts are specifically meant to pay for education expenses and offer tax-free growth.
- Custodial accounts: Also known as Uniform Gifts to Minors accounts (UGMAs) or Uniform Transfers to Minors accounts (UTMAs), these accounts can be used for any expenses that benefit the minor.
Each option has its own unique advantages, depending on your family’s individual needs and circumstances. You also may want to consider diversifying and investing in a combination of accounts.
Although the future may seem an eternity away, it’s never too early to start saving for your child’s future — and a Roth IRA is one investment vehicle worth considering.