If you didn’t already know, anyone with earned income can have a Roth IRA….including children! That’s right, there is no minimum age in the tax code to be qualified for a Roth IRA. All that is required is reportable earned income, and the contributions to the Roth cannot exceed that income.
Let’s be realistic though – not many children are going to think to save their newly hard earned money for a time in their life that seems lightyears away. That’s where the parents, or a generous relative, come in.
Establishing Your Child’s Roth IRA
As soon as a child has earned income, a Roth IRA can be established on the child’s behalf by a family member. That family member can also fund the Roth on behalf of the child, just so long as the amount is equal to or less than the amount earned by the child that year.
So why is this an attractive option? For starters, the Roth IRA is simply a smart savings tool. The assets contributed to the account will grow tax-deferred for decades (assuming the child keeps the account past age 18), including the earnings, and can be withdrawn tax-free, so long as they follow the rules to avoid penalty.
But the really appealing reason to start a Roth for your child is the benefit they’ll receive from the effects of compounding. Let’s say you invest the maximum $5,500 each year for the roughly 40 years of your adult working life. With a hypothetical 8 percent annual return, that puts you at $1.5 million in retirement. Now let’s say you add 10 additional years onto that number for the time you could have had a Roth while earning an income as a child. Due to compounding, and assuming the same rate of annual return, you would have over $3.4 million in retirement – more than double!
Knowing the Rules
It’s very important that parents, family members, or whoever is making the contributions on the child’s behalf keep detailed records of all contributions. The reason being, IRS rules allow for Roth contributions to be withdrawn tax and penalty free at any time, regardless of whether the five-year holding period has been met. And while ideally, most of the funds would be left to grow for retirement in the Roth account, there are a few ways teens and young adults can use the funds sooner.
You can withdraw your contributions, which is the amount that is equal to what you’ve invested, at any time without tax or penalty. And generally speaking, when you withdraw over your contribution amount (essentially, when you withdraw earnings) before age 59 ½, is when you become subject to income tax and a 10% penalty. Here’s where knowing your rules comes in though – there are a few exceptions.
Qualified Education Expenses – If your child attends college, or any higher education establishment, they are able to take penalty-free distributions from their Roth IRA contributions to help cover the costs. This includes expenses like tuition, room and board, and textbooks.
Buying Their First Home – Here’s where an interesting exception to the rules comes in to play. While your child is always eligible to take distributions in the amount of their contributions without tax or penalty, if they are eligible first time home buyers, they can actually withdraw up to $10,000 in earnings from their Roth without the 10% penalty. And if they’ve had the Roth for over five years, they’ll avoid a tax bill on the withdrawal too! The money just has to be used within 120 days of the withdrawal.
Talk to Your Financial Advisor
Before making the move to open a Roth IRA for your child or a child in your family, make sure you speak with a knowledgeable financial advisor. Not every IRA custodian is aware that minors can have a Roth IRA. There are also some IRA custodians that will not allow a minor to open a Roth IRA on their own, but many allow a parent to serve as the guardian on a Roth IRA on behalf of their children.
It’s also important to take your individual circumstance into consideration with your financial advisor. Not every child will have the maturity or commitment to maintain a Roth IRA.
If you have any questions about this strategy, we welcome you to contact any of the advisors here at Walsh & Associates.
The information presented in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. The hypothetical example is not representative of any specific situation. Your results will vary. The hypothetical rate of return used does not reflect the deduction of fees and charges inherent to investing.