Where would you be financially if someone had started a tax-free Roth IRA for you before you could count to 10? Few parents or grandparents think about starting a Roth retirement account for young children. But think for a moment about what an enormous advantage it would be for a young child to have six or seven decades with one of these accounts compounding from birth until retirement.
Opening a Roth IRA for a young child can be the easiest way to create generational wealth!
Basics of Roth IRAs for Kids
Kids are thinking about the next present they will get for Christmas or their birthday. What they are NOT thinking about is how they will support themselves when they are in their 70s and 80s. A Roth IRA for a child is how savvy parents, grandparents, or other family members help jumpstart a child’s retirement savings.
- There are no age restrictions. Kids of any age can contribute to a Roth IRA, as long as they have earned income.
- A parent or other adult will need to open the custodial Roth IRA for the child. Nabers Group is one of the very few non-custodial document providers in the industry providing Roth IRAs.
- Anyone can contribute to the child’s Roth IRA, as long as the total doesn’t exceed the child’s earned income.
- A Roth IRA is more flexible than other retirement accounts because contributions can be withdrawn at any time.
A Roth IRA for kids provides all the benefits of a regular Roth IRA but is geared toward children under the age of 18. Minors cannot generally open retirement or investment accounts in their own name until they are 18, so a Roth IRA for kids requires an adult to serve as custodian.
The custodian maintains control of the child’s Roth IRA, including decisions about contributions, investments, and distributions. In addition, statements are sent to the custodian. However, the minor remains the beneficial account owner and the funds in the account must be used for the benefit of the minor. When the minor reaches the required age, typically either 18 or 21 in most states, the assets must be transferred to a new account in their name.
Nabers Group plans have 100% IRS approval and provide a white-glove experience to our valued account holders.
A Roth IRA Teaches Kids How to Save
About the time most of us reach our late 20s, we finally realize how important it is to be saving for our later years. A few grandparents or parents do a huge favor for youngsters when they buy a few savings bonds with instructions to apply the money towards a college education. Good for grandparents that do that because it is a good lesson in how saving and investing are key to building long-term wealth.
Unfortunately, many Americans lack the discipline to save an adequate amount as a percentage of their income. Learning that lesson early can make all the difference in the quality of a child’s life. As good as a few savings bonds are, opening a Roth IRA for a child is the way to really compound the wealth a child can accumulate in their lifetime.
A Roth IRA for kids is an ideal tool to inspire a lifetime of savings. Roth IRAs allow for both tax-free growth and tax-free withdrawals — which is a tremendous opportunity for young people. Kids have decades ahead of them to save for retirement. That puts them in the prime (and enviable) position to take full advantage of a long-term investment strategy, and the power of compounding.
Anyone can contribute to a child’s Roth IRA
It Doesn’t Have to Be the Child’s Money That Goes Into the Roth IRA
Keep in mind that this can be as much about teaching a child to save as it is about giving them a hand up towards creating wealth. It can be difficult to convince a child to deposit their earnings into their Roth IRA. Although the child must meet the earned income requirement, it doesn’t have to be their money that is actually contributed to the Roth IRA. You or anyone else can make the contribution (or a part of it) on their behalf.
However, the lesson about saving early is an important one. One way you can do this is by not making all the contributions but instead, use a matching fund system. For every dollar that the child contributes, you contribute a matching amount. For the year 2022, the maximum contribution can be $6,000. So, if the child contributes $3,000, you could match that with $3,000 to add up to the maximum amount. In 2023, the maximum increases to $6,500.
However, keep in mind that total contributions cannot exceed the child’s earned income. If the child earned $5,000 babysitting during the year, that is the maximum amount allowed for all contributions. Not many children will have to be concerned with the income limit that applies to Roth IRAs but the Roth IRA income limits for 2022 are less than $144,000 for single tax filers and rise to $153,000 in 2023. If the child makes more than those numbers, they don’t qualify for a Roth IRA. The number that you look at for this is the child’s modified adjusted gross income (MAGI).
Compounded investment earnings give the child a much better chance of building a multi-million-dollar nest egg than playing the lottery does.
Roth IRA Versus Traditional IRA for Kids
This strategy works with a traditional IRA but when it involves a child, the Roth IRA makes much better sense for at least four good reasons.
- Because contributions are based on earned income, the child might need to file an income tax return. However, the child’s income is likely to be low enough that little or no taxes will be due. The big advantage of a traditional IRA is the tax deduction. Owing little or no taxes as a child can make the Roth contributions completely tax-free, now and in retirement years.
- Roth IRA withdrawals are 100% tax-free after age 59½ when your child is likely to be in a higher tax bracket than they are now. Chances are good that they will be able to retire at that age. Or if they choose to continue working, they could start taking tax-free withdrawals that significantly increase their income after age 59½.
- And it gets better because Roth IRAs and Roth Solo 401ks are more flexible. You can withdraw Roth IRA contributions (but not investment earnings) before age 59½ — tax-free and penalty-free at any time. That means the child could use some of the IRA money for big expenses in young adulthood, such as college costs or a first-time home purchase.
- Another advantage to keep in mind is that, unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) when you reach a certain age. That means the account can continue to grow for an entire lifetime.
Because there are no RMDs, a Roth IRA can be an ideal wealth-transfer vehicle to create legacy wealth.
One potential downside of a Roth IRA for kids is that your child may eventually make too much money to continue funding the account. Of course, that’s not necessarily a bad position to be in — and even without additional contributions, the account will continue to grow tax-free. And there is the Mega Backdoor Roth IRA that can be used to continue funding the account.
Put Your Child’s Tax-Free Earnings to Work
Eligible income can include formal employment income, self-employment income, or even monetizing a hobby. Activities like babysitting or mowing lawns can qualify a minor for Roth IRA contributions. It’s worth noting that in some cases self-employment taxes (Medicare and Social Security) can apply so it’s advisable to consult with a tax professional. If your child is not filing a tax return that reports his or her earned income, you should maintain a written log of their earnings in case the IRS asks questions. Unlike traditional IRAs, contributions to Roth IRAs are made with after-tax dollars. This means the account owner cannot claim a tax deduction for his or her contributions. However, since most kids have low annual earnings, their income tax rate is already quite low or even zero. Therefore, tax deductions may not be a crucial factor at this stage of their lives. Moreover, when it comes time to tap their savings at retirement age, distributions from a Roth IRA will be tax-free, unlike distributions from a traditional IRA.
Fun Facts About a Roth IRA for Kids
Starting young means a lot more time to grow tax-free earnings. It’s about compound interest and alternative investments. It’s a simple math fact that Albert Einstein called the 8th wonder of the world.
“Compound interest is the eighth wonder of the world. Those who understand it, earn it; Those who don’t, pay it.”
~ Albert Einstein
The average person catches on to this and has about 30 or 40 years to save for retirement. A kid who starts earlier has the benefit of much more time. If your kids leave their money in the Roth IRA until retirement, they could be looking at 50 or more years of investment growth, completely tax-free. Just think about the power of compound interest at that age. A one-time contribution of $6,000 in a Roth IRA — with no additional contributions at all — would grow to about $200,000 in 60 years — assuming a 6% investment return and monthly compounding.
Next, compound that even more with investing rather than just saving. At best, most young kids open a savings account, and we all know how little interest those have been paying for many years. With a Roth IRA, you can teach your child how much better they can do with wise investments. You can guide them, but it might be a better lesson to let them at least pick some of their own investments. Think about how much further ahead they’ll be compared to most 8- or 12-year-olds.
An initial $6,000 investment with $500 added monthly and earning 11% that compounds monthly for 60 years will be worth more than $43 Million.
It’s worth repeating that tax advantages are prime for kids. With a tax-free Roth IRA, all that growth is earned completely tax-free if your kid follows the rules for distributions. The Roth’s tax treatment is especially valuable when your time horizon is long and your current tax rate is low, and both of those are true for children. In fact, the earnings of most kids are so low that they pay little to no income taxes, meaning they avoid taxes on contributions, too — it’s amazing to think about TOTALLY TAX-FREE INVESTING!
The money is available for more than retirement. It is a retirement account, but it can also be much more. Contributions (but not earnings) can be pulled out at any time and for any reason. But there are also a couple of loopholes that can get your kid access to the investment earnings before age 59½. After the Roth IRA has been funded for five years, your child can take out up to $10,000 in earnings to buy a first home, tax- and penalty-free. Roth IRA earnings can also be used for qualified education expenses, like college tuition. Earnings distributed will be taxed as income, but there will be no penalty.
The financial takeaway for a child’s Roth IRA. Setting up a Roth IRA for your kids now can help them secure a comfortable retirement later. By starting a Roth IRA at a young age, your child can take full advantage of the power of compounding.
A Roth IRA for a child can foster a lifetime of healthy money habits.
Set Up A Self Directed Roth IRA So Your Child Can Start Investing In The Future
If you want your child to build wealth, you can take action today toward that goal. According to The National Study of Millionaires, 3 out of 4 millionaires (75%) said that regular, consistent investing over a long period is the reason for their success. Regardless of where their income comes from, they actually save money and invest!
Book a free call with one of our experts now to learn your options and discuss what is best for you!
