A Roth IRA is an excellent retirement savings vehicle for many of us. What you might not know is that a Roth IRA can be an excellent option for your kids as well.
What Is a Roth IRA for Kids?
Roth IRAs are retirement accounts where the money is contributed after-tax. If certain rules are followed, the money can be withdrawn tax-free once the account holder retires. The money in the account grows tax-free while it is invested.
Roth IRAs have the same annual contribution levels as traditional IRAs. For those who are under 50, the maximum annual contribution is the lower of $6,000 or the amount of earned income generated by the account holder for the year. Roth IRA contributions can be made for the prior tax year up to and including the tax filing date for that year, excluding extensions. This is generally April 15.
A Roth IRA account can also be an ideal investment for minor children for a number of reasons.
Advantages of a Roth IRA for Kids
Roth IRA accounts have several attributes that make them advantageous for kids, not only during their childhood but also throughout their lives. Opening a Roth account for a child can provide a good start on future savings habits in an account that can offer a number of advantages through various life stages for them.
Contributions Can Be Withdrawn at Any Time
Retirement accounts generally assess a penalty and taxes when funds are withdrawn prior to age 59½. With a Roth IRA, the money contributed to the account can be withdrawn from the account at any time for any reason.
This only applies to the money contributed to the account, any earnings on the funds contributed may be assessed with a 10% early withdrawal penalty and the amount that is withdrawn may be subject to income taxes as well.
No Penalty for Higher Education Expenses
Earnings from the account can be withdrawn from the Roth IRA account if used for qualified educational expenses such as college. The earnings will be taxed, but there is no 10% penalty. And, of course, the student can withdraw their contributions tax-free.
Exceptions for Buying a First Home
Once five years have elapsed since the initial funding of a Roth IRA account, the child can withdraw up to $10,000 in earnings from the account tax and penalty-free to buy their first home. This can go a long way towards giving your child a head start on homeownership.
A look at the types of distributions that can be taken at various stages of the child's life as they move into adulthood will help illustrate why opening a Roth account for your kids can be a great option:
Qualified Roth Distribution Options
Qualified distributions can be taken from the account penalty-free and tax-free at various stages of life. In order to be considered as a qualified distribution, the five-year holding rule must be met. Essentially this rule says that five years must have elapsed since your initial contribution to any Roth IRA account. Qualified distributions include:
- Those made on or after the account holder reaches age 59½.
- Distributions are taken in connection with a disability.
- Distributions made by a beneficiary of the account or your estate in the event of the account holder's death. Note that a surviving spouse can treat the Roth account as his/her own upon the account holder's death.
- The distribution is used to buy, build or remodel a first home.
Non-Qualified Roth Distribution Options
Non-qualified Roth distributions are those that don't fit as qualified Roth distributions. They are generally subject to income taxes and potentially a 10% penalty as well. In some cases, the 10% penalty may be waived, these exceptions include:
- If the distributions are part of a substantial series of withdrawals that lasts for at least five years or until age 59½, whichever is later.
- To cover unreimbursed medical expenses that exceed 10% of adjusted gross income (AGI).
- To cover the payment of health insurance coverage in the event of a job loss.
- If the distributions do not exceed the cost of higher education expenses for the account holder or qualified family members.
- If the distribution is due to an IRS levy against the account.
- A qualified reservist distribution.
- A qualified disaster recovery assistance distribution.
Eligibility Rules for Kid's IRAs
In order to contribute to a Roth IRA, the child must have earned income from some kind of employment or self-employment. This income could come from a part-time job such as working in a store after school or on weekends. If the parents own a business, the child could be put on the payroll. They would need to be paid W-2 wages just like any other employee. This can be an ideal way for parents to shift some income from their business to their children while setting them up with a solid savings vehicle for retirement and other life goals.
The income could also come from self-employment gigs like lawn mowing, dog walking or babysitting. Even if the parent actually makes the contribution, the child must have enough earned income.
Note there is no minimum age requirement in connection with a Roth IRA account.
How to Open a Roth IRA for Your Child
It's important to understand that while the child's earned income will be the income considered in determining whether and how much the child can contribute to the account, most custodians will require that an adult be the one to open the account on behalf of the minor.
The account will actually be a custodial Roth IRA for the child.
Opening these accounts is generally pretty simple. You will need the child's Social Security number, their date of birth and other typical information. It will depend upon the custodian as to whether or not the account can be opened online or if it must be done by mailing in a form, or in person.
Opening a Roth IRA for your kids is a great option now as a way for them to make the most of earned income from a job or from self-employment such as babysitting.
The account can be used for college expenses and other needs beyond retirement. Beyond this, having your kids put some of their earnings into a Roth IRA can be the first step in showing them the benefits of good savings habits that will carry through life.