A Custodial IRA (Individual Retirement Account) is a type of tax-advantaged retirement savings account established for a minor by a custodian, who is usually a parent, guardian, or another responsible adult.
The purpose of a custodial IRA is to help minors save for their future retirement or education expenses while benefiting from the tax advantages of an IRA. Starting to save for retirement at such an early age adds several years or decades for their contributions to grow and compound tax-free.
How does a custodial Roth IRA work?
The custodian, which is usually the parent or guardian of the child, manages the account on behalf of the minor until the minor reaches the age of majority (usually 18 or 21, depending on the state). That means, as the custodian, you’re responsible for making all investment decisions in the account until your child reaches majority age. Once the minor reaches the age of majority, they gain full control of the account and can make investment decisions and withdrawals as they see fit.
Once your child reaches the age of majority, and the account’s control is transferred to them, they are free to do whatever they like with the account. The custodian has no power over the account at this point.
Is my child eligible for a custodial Roth IRA?
There are no age restrictions. Any minor is eligible to contribute to a Roth IRA, as long as they have earned income during the tax year, and a custodian is able to establish the plan for them.
What counts as earned income? Any income earned during a tax year qualifies as earned income. For example, if your child earns money from babysitting, a paper route, or from a summer job, that all counts as earned income.
Does allowance count as earned income? No allowance for doing chores around the house does not count as earned income. The money must come from a job with an employer, or from a business that they own.
There are two main types of custodial IRAs
Custodial Traditional IRA: Contributions to a traditional IRA may be tax-deductible, depending on the contributor’s income and tax-filing status. The earnings in the account grow tax-deferred, meaning taxes are not paid on the growth until the funds are withdrawn in retirement. Withdrawals are generally taxed as ordinary income, and required minimum distributions (RMDs) must be taken after the account holder reaches age 72.
Custodial Roth IRA: Contributions to a Roth IRA are made with after-tax dollars, meaning there is no immediate tax deduction. However, earnings grow tax-free, and qualified withdrawals in retirement are also tax-free. There are no required minimum distributions for Roth IRAs, providing more flexibility for the account holder.
Custodial Roth IRA vs Custodial Traditional IRA
One of the drawbacks of a Roth IRA is that it gives you no tax deductions on your contributions, while contributions to a traditional IRA get deducted from your taxable income. However, since minors are usually in the lowest tax bracket, and often have no taxable income, not being able to get a tax deduction is not a major concern.
For minors who can compound their contributions for decades, the tax benefits of a Roth IRA highly outweigh the tax deductions they might receive on their low incomes. With a Roth IRA, withdrawals in retirement are completely tax-free, no matter how large the gains.
For example, if you contribute $1,000 to a Roth IRA when you’re a minor, and it grows to a value of $1 million by the time you retire, you’ll owe zero taxes when you withdraw the entire million dollars.
Best features of a Roth IRA
A Roth IRA is more flexible than other retirement plans and is the perfect account for minors starting to save at an early age. Here are some of the best features of a Roth IRA.
Tax-free withdrawals in retirement: With a Roth IRA, you contribute with after-tax income, but your withdrawals in retirement (after the age of 59½ are tax-free). If you have the luxury of compounding your money for a longer period of time than the average person, having it in a Roth retirement account gives you a significant tax advantage over having it in a traditional account.
Withdraw contributions at any time: With other retirement plans, you’re not allowed to make any withdrawals from your account before you reach the eligible withdrawal age of 59½. If you withdraw before the age of 59½, it gets hit with a 10% early distribution penalty plus income taxes on the amount you withdrew. However, a Roth IRA lets you withdraw your contributions at any time without any penalties or taxes. For example, let’s say a minor contributed $5,000 over the years, where it got invested and grew to a value of $20,000. The $5,000 in contributions can be withdrawn at any time, but the $15,000 in earnings cannot be withdrawn before the eligible withdrawal age.
No Required Minimum Distribution (RMD): With other retirement accounts, you’re required to start taking distributions once you reach the age of 73. The Roth IRA is the only retirement account that does not have a RMD rule, allowing you to continue compounding your money tax-free in your account while you are still alive.
Contribution limit of a custodial Roth IRA
The contribution limit of a custodial Roth IRA is the same as a regular Roth IRA. Minors can contribute up to 100% of their earned income up to a maximum of $6,000 for 2022 and $6,500 for 2023.
How to open a custodial Roth IRA
A custodial Roth IRA only takes around 15 minutes to open and can be done completely online through many major banks and brokerages. You’ll only need Social Security Numbers for the custodian and the minor and personal information like birthdates, addresses, etc.