What to know about opening a custodial Roth IRA for a child

What was your first job? Maybe you bagged groceries, mowed lawns or babysat the neighborhood kids. In any case, you remember just how exciting it was to dip your toe into the working world. And also to make your own money. Now that that time is here for your child, it's only natural for them to spend some of their paycheck on short-term wants. As a parent, though, it's important to show them that planning for their future also is essential. You have an opportunity to help them explore more of the financial realm and the different tools they have for saving their earnings.

A custodial Roth IRA is a valuable option to consider. Because they have earned income, you can open this retirement savings account on your child's behalf. It can offer them more than what a simple savings account can—enabling them to benefit from compound growth and learn about tax advantages while also giving them a head start on a lifelong financial journey.

A custodial Roth IRA is a retirement account that's owned by a minor but managed by an adult. In most respects, a custodial account works just like an ordinary Roth IRA. You invest post-tax dollars that you can allocate toward a variety of investments, such as stocks, bonds, mutual funds and exchange-traded funds.

Like a regular Roth IRA, the account balance grows on a tax-deferred basis. Your child can access their contributions tax-free and penalty-free at any time, and the earnings withdrawals made after they reach age 59½ will be tax-free. Because it's meant to be a retirement savings vehicle, any earnings taken out before then may be subject to income taxes and a 10% early withdrawal penalty.¹

As the custodian of your child's account, you'll make the contributions and select investments on their behalf. Your child will be required to assume control of the assets at age 18 or 21, depending on your state's law. At that point, they can open a regular Roth IRA independently, and the balance will be transferred to the new account.

As with other Roth IRAs, the owner must have earned income to qualify. As long as your child has a job or makes money through activities like babysitting or lawn-mowing, you can open an account in their name.

For 2024, the annual contribution limit for a custodial Roth IRA is $7,000, but the amount contributed also can't exceed your child's earnings. For example, if they earn $2,000 during the year, they only can put $2,000 into the IRA. Both you and your child can fund the account, enabling you to help pad their nest egg, although the annual limit applies to the combined contributions from all parties.

Because of the earned income limit, keeping accurate records is critical. This can be easy to do if your child has a job that generates an annual W-2. But if they receive income from informal employment, encourage them to create invoices for the work they perform and the compensation received for it.

While retirement may seem like a distant goal for a kid, saving now offers several advantages that can pay off in the long run.

Any investment returns generated in an IRA—whether realized capital gains, dividends or interest—are automatically reinvested to purchase more shares. Therefore, your child's earnings generate additional earnings, creating a snowball effect. This process, known as compound growth, is even more powerful for younger investors because they have more years for their returns to multiply. Over longer time periods, teens and pre-teens have the potential to achieve greater returns than interest borne from a savings account, although they should understand the risks inherent to investing as well.

Your child can withdraw contributions tax-free and penalty-free at any point. Whatever earnings they receive also are tax-free, as long as they make a qualified withdrawal (examples are discussed in the next section). As a result, they have the potential to obtain a much higher after-tax return on their investment than they would through a fully taxable brokerage account.

Roth IRAs are designed to encourage individuals to save for their retirement. But because your child can withdraw contribution amounts without paying a tax or penalty, they still have access to some of the IRA assets if a financial need arises sooner.

There are also certain situations where you can withdraw earnings before age 59½ and avoid the early withdrawal penalty (but not taxes), such as:

• Eligible college expenses
• Qualified birth and adoption costs
• Medical insurance premiums, if:
  
  • You lost your job.
  • You received unemployment compensation under any federal or state law for 12 consecutive weeks.
  • You took distributions the year you received unemployment compensation or the following year.
  • You received distributions no later than 60 days after returning to work.
• Unreimbursed medical expenses (that would qualify for a medical deduction) in excess of 7.5% of your adjusted gross income (AGI)
• Disability needs

Creating a Roth IRA for your child helps them develop money management skills that they'll draw upon throughout their life. When you invest money on their behalf, you have an opportunity to explain how securities like stocks and bonds work and how to build a suitable asset mix. It's also a good way to create realistic expectations for the future. They'll likely find that some stocks that suddenly drop in value eventually rebound and vice versa, which can help them avoid overreacting to short-term fluctuations.

Custodial IRAs can be either traditional or Roth IRAs, although the latter tend to be more common for minors. The main reason is that most youngsters will get a bigger tax break from a Roth account.

Unlike Roth IRAs, traditional IRAs allow you to deduct your contributions from your taxes but require you to pay income tax when you make withdrawals in retirement. By then, most kids will be in a higher tax bracket than they are today. What makes Roth accounts appealing for younger investors is that the upfront tax benefit that they forgo—the ability to deduct contributions on their tax return—is usually less significant than the perk of being able to make tax-free withdrawals later in life.

There are other advantages to a custodial Roth IRA over a traditional IRA as well. For example, your child won't have to make required minimum distributions when they reach a certain age. They also have more options if they want to access part of their money early.

As long as your child has earned income, you can go to any Roth IRA provider and open a custodial account in their name. The application will ask for basic information about the parent, such as your Social Security number and driver's license number.

You would then fund the account with an amount that meets the institution's minimum opening deposit requirements. Later on, you can link a bank account that belongs to you or your child to make additional contributions.

With the ability to benefit from compound, tax-free growth, custodial Roth IRAs can be an effective way to prepare your child for future financial needs. However, before opening an IRA for your child, be sure to consider their investment objectives. If they plan to use the money for college expenses, you may want to explore other options, such as a 529 education savings plan, that allow for the tax-free withdrawal of earnings for education expenses.

If you need guidance finding the right savings strategy for your minor, connect with a Thrivent financial advisor who can put your family on the right path.