Opening A Custodial IRA For Your Child
Parents are always looking for ways to ensure their children’s success, and there’s one simple action you can take now to positively impact your child’s financial future for years to come.
If your teenager earns an annual income through a summer job or part-time gig, consider opening an investment account on their behalf to help them prepare for retirement. While your child’s retirement is decades away, creating and contributing to this account early can give them financial freedom down the road thanks to the account’s compounding capabilities.
Types of Custodial IRAs
If your child has an annual income, two types of custodial Individual Retirement Accounts (IRAs) can be opened and managed on their behalf:
- Traditional IRA – Contributions to a Traditional IRA are tax-deductible. Investments in the account can grow tax-free, though withdrawals are subject to ordinary income taxes.
- Roth IRA – Contributions to a Roth IRA are made with after-tax dollars. Investments in the account also grow tax-free. While contributions are not tax-deductible in the current year, qualified withdrawals are tax and penalty-free.
The Case for Roth IRAs
To contribute to a Roth IRA, your child must have earned income. If your child works part-time, their annual wages are likely less than the standard tax deduction, which means they may not owe any federal taxes at all. When they eventually make qualified withdrawals during their retirement, they will not owe taxes on their earnings, regardless of their tax bracket and any tax rate hikes that may have occurred in the interim.
In addition to these tax benefits, Roth IRAs also offer:
- Compound interest
- Diversification and investment options
- No age restrictions on contributions
- No mandatory withdrawals
- No income taxes for inherited accounts
- Not includible in taxable estate
How to Open & Contribute to a Roth IRA
To open a custodial Roth IRA, you’ll need your child’s Social Security number. Once opened, a parent or guardian will be responsible for managing the account until the child reaches the age at which they can hold the account in their name only – ranging between 18 and 25 years old, depending on the state.
Contributions to custodial Roth IRAs may not exceed either the child’s earned income or the annual contribution limit of $7,000 (as of 2024, increases annually for inflation). It’s important to note that your child’s income must be reported to the IRS, whether it be from self-employed gigs, lawn mowing, babysitting or other part-time jobs.
Impact to Tuition Aid
Another benefit to custodial Roth IRAs is that they are not reported on the Free Application for Federal Student Aid (FAFSA), meaning they will not impact your child’s potential for tuition aid. However, if a distribution is taken, the value must be reported as income on a future FAFSA form, which could affect financial aid eligibility.
While a Roth IRA’s benefits cannot be overlooked, it’s important to consider how the account fits into the greater financial plan that you have for your child and your family. For support in opening and managing a custodial retirement account, connect with the financial experts at SST Accountants & Consultants.
