Starting a Roth IRA for Your Kids (2024)

When saving for retirement, finance gurus preach that starting early is the best strategy. This is why you should consider helping your child set up a Roth IRA as soon as they start earning income.

A Custodial Roth IRA is a specialized account designed for minors, allowing parents or guardians to open and manage the account on behalf of the child until they reach the age of majority. Contributions to this account are made with after-tax dollars, meaning withdrawals, including earnings, can be tax-free if certain conditions are met.

Keep in mind that your child's IRA contribution can only be done if your child has earned or taxable income. The income can be from any source, such as babysitting or mowing the lawn (ideally not yours). Unfortunately, allowances aren't a legitimate source of income; but you may be able to pay your child for work done around the house, provided it is legitimate work, and the pay is at the going market rate.

If you are worried about taxes, the good news is that babysitting money is exempt from paying self-employment tax as teenage babysitters are normally considered employees. If a child under 18 is working part-time as a household worker (babysitting, gardening, housecleaning, home repair), he or she is also exempt from the self-employment tax.

The Pros and Cons of Roth IRAs for Kids

Pros:

1. Tax-Free Growth: One of the primary advantages is the tax-free growth potential of a Custodial Roth IRA. Since contributions are made with after-tax dollars, qualified withdrawals, including earnings, are tax-free.
2. Early Start for Compound Growth: Starting early can be the key to investing success. For example, if a 15-year-old contributes $7,000 in 2024 and can compound that money at 10% per year, s/he would have over one million dollars by age 70 - and this is with just one contribution! Imagine the power of compounding if you max out the Roth contributions on a yearly basis.
3. Educational Expenses: Custodial Roth IRAs can also be used for educational expenses without incurring the usual penalties for early withdrawals. This flexibility makes it a versatile tool for funding both retirement and education goals.
4. 529 rollover opportunity: Some people find that they have leftover money in their 529 plans. It is now possible to perform a rollover from a 529 to a Roth IRA up to $35,000 per beneficiary. There are some limitations as the 529 plan must be open for at least 15 years and any contributions made within the past 5 years are ineligible to be moved into the Roth IRA.

Cons:

1. Limited Contributions: The annual contribution limit is the same as a regular Roth IRA, and it is important to be aware of these limits to avoid any potential issues. For 2024, the maximum contribution is $7,000; and your child would need to earn at least $7,000 to max out the contribution. If your child earns $3,000 during the year, then their maximum Roth IRA contribution is $3,000.
2. Risk of Child's Early Access: Upon reaching the age of majority (typically 18 or 21 depending on your state), the child gains control of the account. This could potentially lead to early withdrawals or mismanagement if the child is not financially responsible. It also pays to teach kids about money!
3. Impact on Financial Aid: While contributions to a Custodial Roth IRA do not impact federal financial aid calculations, withdrawals may. This could affect a child's eligibility for certain financial aid programs.

Conclusion

While tax laws could change over time, we believe in the adage of starting to invest as early as possible. If you help fund your child's Roth IRA, the tax advantage can be massive, and you just might help pave their way to a million dollar retirement.

If your child earned money from babysitting money or a summer job, what's holding you back from opening a Roth IRA?