A Roth IRA for kids. Originally, this was a befuddling idea for brokerages — an IRA for minors? But now marketers admit that over the past two to three years, there’s been an uptick in interest in it. Parents who may have seen their own savings fall short and their pension guarantees erode are moving proactively to get kids started now.
The potential for this kind of investing is really mind-blowing. Money can be stashed in a kid’s Roth, where it will grow tax-free as long as he or she keeps it there — potentially for the child’s lifetime.
Usually a parent or grandparent controls Roth IRAs for kids, but the account is opened in the child’s name.
Here are a few of the requirements for putting money into a Roth for your child:
- The child must have earned money during the tax year.
- The adult who opens the account has to document that the income was earned from work, what work was rendered, when it was done and the payment.
- Contributions you make to the kid’s Roth can be a gift, but then the IRS gift tax rules apply.
Convincing your kids to use their summer earnings to invest in an IRA is a pretty tough sell but an excellent idea, especially if you sweeten the pot a little by offering a match in the form of a little extra spending money. Not only will modest contributions add up to significant savings come retirement, but here’s also a lesson that’s unlikely to be taught in school.
Why a Roth IRA?
- Contributions can be withdrawn at any time without any tax hit. (There may be an early withdrawal penalty, depending on the reason for the withdrawal.)
- The child won’t lose out on any financial aid benefits when it’s time to go to college, because the financial aid number crunchers don’t count IRAs as assets; they’re invisible when it comes to determining financial aid eligibility. Some financial planners regard the Roth as a complement to or a substitute for popular 529 college savings accounts. Do keep in mind that any withdraws made down the road to pay for college are viewed as income.
- Kids get no deduction as the money goes in — they probably don’t need any — but they get to enjoy a full tax exemption on money coming out.
For teens working summers, the choice is not tough at all — upfront deductions are worthless because they’re probably in a 0 percent income tax bracket.
The same rules that decide eligibility for Roth IRAs apply to the account you open for your child:
- You or another adult will be the custodian on the account, but the child will be the owner. That’s why it’s called a custodial IRA.
- The adult controlling the account is the only person who can make investment decisions.
- When the kid turns 18, or 21 in some states, you can take steps to shift the account to his or her control.
The big benefit of Roth IRAs is that whatever money you earn from your investments won’t be taxed when you withdraw it, but the money must be held for at least five years to get the full tax benefit. Additionally, contributions can be made up to the annual Roth IRA limit, which may change from year to year.
Will your offspring honor the promise not to touch the money for 50 years? The IRS will help out by threatening a penalty on the earnings if there are any early withdrawals. However, there may be exceptions for the purchase of a home.
For the specifics on Roth IRA tax rules, contact your financial planner or tax expert.
