Make Lasting Impact for Children and Grandchildren with a Custodial Roth IRA
Some of our clients—particularly those nearing or in retirement—have found that custodial Roth IRAs are perfect for introducing younger generations to the values and rewards of financial planning. And for you, the grantor, they offer a recognizable and trusted investment tool through which you can begin building wealth for those young ones (and maybe not so young ones) most important to you. Talk about giving your heirs or grand-heirs a leg up!
What is a custodial Roth IRA?
Simply put, a custodial Roth IRA is a Roth IRA for someone under the age of 18 (or 21 in some states) who has earned income. Because most brokerages don’t allow minors to open and operate accounts on their own, you’ll have to designate an adult to open and manage the custodial Roth IRA until the minor turns 18.
What’s great about a custodial Roth IRA is that it works almost exactly like a standard Roth IRA with only a few notable differences. For starters, both accounts are designed to be used for retirement and are funded with after-tax dollars (with an annual cap to contributions). For tax year 2022, that cap is $6,000 or the amount of the child’s earned income for the year, whichever is less.[1] Contributions can be withdrawn at any time, and earnings from investments can be withdrawn tax-free and without penalty after age 59½. These are some of the perks that make Roth accounts so attractive!
How does a custodial Roth IRA differ from a standard Roth IRA?
The most obvious difference has to do with who opens and manages the account. That said, it’s important to keep in mind that once your child or grandchild turns 18, they assume full control of the account, including the ability to make decisions about withdrawals. This might sound scary as the custodian. After all, eighteen is still so young. As you may have heard us mention before, our sounding board meetings are designed specifically for this reason. If they are important to you, they are important to us, we have a process around providing financial education for your loved ones. This way, the custodian can help guide the child or grandchild to make wise decisions with the money.
You’ll also want to keep in mind that your child or grandchild must have earned income. Although this isn’t a difference, per say, it is worth highlighting, as it’s one of the key factors determining whether you can open an account on their behalf. However, this is an area where you’ll be rewarded for thinking creatively, because earned income doesn’t have to begin with your teenager’s first W-2 job. Many of our clients help their child or grandchild start much earlier, encouraging them to seek out paid jobs like housecleaning, neighborhood yard work, or social media consulting (for their business or someone else’s).[2] Their earned income can even begin with baby image licensing!
As long as the work is properly documented and the child or grandchild files an income tax return, you can open an account for them and they can begin contributing. Just remember that the maximum annual contribution to the account is pegged to their income, not yours. So, if they only make $1,000 during the year, that would be the cap for contributions. Also, if you yourself prefund the account and your child or grandchild earns less than expected, you’ll have to withdraw any excess contributions and associated earnings before the next tax filing deadline.[3] But this is a simple transaction we help our clients with as we review their financial plans toward the end of the year.
Why open a custodial Roth IRA?
- Financial Empowerment
Custodial Roth IRAs confer all the benefits of standard Roth IRAs, which is why they’re an excellent vehicle to help steer your child or grandchild toward financial empowerment. And because there is no minimum age requirement to open a custodial Roth IRA, you can you’re your favorite minors begin building wealth through tax-free compounding long before starting on their career.
Here's an example taken from one of our clients using this strategy: The oldest grandchild has contributed $2,000 annually (approximately $165 per month) to their investment retirement account starting from age 10. With a 7% rate of return and without any withdrawals, this child is expected to accrue $1 million or more prior to turning 65.[4]
- Tax Savings
Not only that, but most clients’ children or grandchildren are in a significantly lower tax bracket at the start of their earning years compared to later in their career and during retirement, so their tax burden during the years of custodianship are negligible compared to the investment earnings they’ll be able to withdraw tax-free after age 59½.
- Increased Earning Power
Another factor to consider is earning power. As your child’s or grandchild’s earning power grows over the course of their career, they may run into Roth IRA contribution limits. For instance, a single person filing taxes in 2021 had to have an adjusted gross income of $125,000 or less to contribute to a Roth IRA.[5] Although this may pose a problem for someone in their prime earning years, for many teens and pre-teens it doesn’t, providing further impetus to start investing early.
- Penalty-Free Early Withdrawals
Our clients also like to use custodial Roth IRAs to save for college since Roth accounts allow for penalty-free early withdrawals for qualified education expenses (provided the account has been open for five years). Those exemptions include college tuition, fees, books, supplies, and room and board, and up to $10,000 toward the down payment or closing costs on a home.[6]
Flexible Options, Endless Possibilities
All told, our clients are amazed at how flexible the options are with a custodial Roth and love being able to use them to help their children and grandchildren begin investing in their future. As Jordan Wexler, CEO of EarlyBird, puts it: “The foundation of a healthy financial future is understanding investing, and Roth IRAs offer a really great entry point to understanding making money and spending and budgeting, and introducing the idea of compound interest and being able to put money away.”[7]
[1]https://www.irs.gov/retirement-plans/traditional-and-roth-iras
[2]https://www.forbes.com/sites/greatspeculations/2016/07/28/turn-your-kids-into-millionaire-retirees-with-a-roth-ira/?sh=6b3c66957d6b
[3]https://www.kiplinger.com/article/retirement/t046-c000-s004-seed-a-roth-ira-for-your-grandkids.html
[4]https://www.retireguide.com/retirement-planning/investing/accounts/ira/roth-ira-for-grandchildren/
[5]https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021
[6]https://www.retireguide.com/retirement-planning/investing/accounts/ira/roth-ira-for-grandchildren/
[7]https://www.today.com/money/roth-ira-kids-how-it-can-set-them-success-t210683
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual SA Piggush Financial Consultants and LPL Financial do not provide legal advice or tax services. Please consult your legal advisor or tax advisor regarding your specific situation