By taking advantage of this retirement account, you can set your child up for future financial success.
Although we associate retirement with seniors, the quality of someone’s retirement usually rests on how well they prepare in the time leading up to it. The more time someone has to financially prepare for retirement, the better, which is why it’s never too early to begin thinking about your children’s retirement.
One tangible way you can help prepare your children for retirement is by opening a custodial Roth IRA.
How custodial Roth IRAs work
Roth IRAs are a type of retirement account that allows you to contribute after-tax money that grows tax-free, with tax-free withdrawals in retirement. Having the ability to have your investments grow tax-free is an amazing gift from the IRS because it can easily save you thousands of dollars over the long run.
A custodial Roth IRA is specifically designed for minors who have earned income. It has the same tax benefits as a regular Roth IRA, but it must be managed by a parent, guardian, or other custodian until the child reaches their specific state’s age of maturity (either 18 or 21). Once the child reaches this age, the account is transferred into their name, and they can control it like a regular Roth IRA.
The key part of a custodial Roth IRA is that the child must have earned income, so not all children will be eligible for one. This can be from formal employment, like a summer job at a restaurant, or self-employment income from things like babysitting or yard work.
The annual contribution limit to a custodial Roth IRA in 2023 is the lesser of $6,500 or your child’s earned income. For example, if your child earns $3,000, the annual limit is $3,000. If they earn $8,000, the annual limit is $6,500.
Early withdrawals (before retirement) from a custodial Roth IRA can be made for qualified higher-education expenses — such as tuition, books, and student activity fees — or toward the purchase of a first home. However, if the withdrawal is made for non-qualified expenses, you could face a 10% early-withdrawal fee and owe income taxes on the amount.
Opening a custodial Roth IRA
Opening a custodial Roth IRA is a relatively simple process. First, decide which platform you’d like to use. Common choices are Fidelity, Charles Schwab, Vanguard, and other major brokerage companies. If you currently have a brokerage account or IRA, you may want to stick with that company because of familiarity and having your accounts in one place.
Once you decide on a company, you’ll fill out an application. Once approved, you’ll be able to start the process of transferring money into the account.
The money in a custodial Roth IRA is intended to be invested, not used as a traditional savings account. This doesn’t (and shouldn’t) have to be complicated, though. You don’t need to handpick many individual companies; you can just rely on a broad-based index fund, like one that mirrors the S&P 500.
An S&P 500 exchange-traded fund (ETF), like the iShares Core S&P 500 or Vanguard S&P 500 ETF, checks many of the boxes investors often look for in investments: diversification, long-term stability, low cost, and a proven track record.
Why it’s important to start as early as possible
Due to compounding, time is one of the greatest things on an investor’s side. Compound earnings are when the money you make on investments begins to make money.
Imagine you begin contributing $3,000 annually to your child’s custodial Roth IRA when they’re age 15 and start making money working. If those investments earned 8% annually, the account would be over $9,700 when they turned 18. If the child never contributed another penny and let the account grow until they were 60, it would be worth over $245,700, with 8% average annual returns.
The smart thing would be for your child to continue contributing and investing in the Roth IRA as long as they’re eligible. The above example shows the importance of starting investing for retirement early and how powerful time can be.