A custodial individual retirement account is one that you open for your child with yourself as a custodian. Like any other custodial account, the money is your child's, but you take care of it for her until she reaches the age of majority. At that point, complete ownership of the account reverts to her. You can withdraw from a custodial account just like you would from a regular IRA, but with the caveat that the money you're withdrawing is your child's and should be used for her benefit.
Custodial vs. Custodian
The concept of a custodial IRA account can be a bit confusing. Every IRA technically has a custodian. The firm that holds your IRA is the IRA's custodian because it watches over your money and keeps it separate from you. In a custodial account, there's an additional level of supervision. You serve as the custodian for your child, who has an IRA account that, like any other IRA, has an IRA custodian. In other words, a custodial IRA has two custodians.
The IRS allows penalty-free withdrawals from IRAs in a few limited circumstances, including withdrawals to pay for health care expenses that exceed 7.5 percent of adjusted gross income or withdrawals to pay for higher education expenses. While your child will still have to pay income tax on the withdrawal, if your child has a minimal income tax rate, the cost won't be that high.
Withdrawing from your child's IRA for any other reason than those stated above carries a 10 percent penalty. Unfortunately, paying for summer camp, buying back-to-school clothing or purchasing a first car are all costs that trigger a penalty. Drawing from your child's IRA also carries a second penalty. Financial aid offices won't consider your child's IRA as part of their calculations of your child's assets as long as it sits there. If you or your child take a distribution while the child is in college, though, it will be included in future calculations.
Custodial Roth IRAs
If you think your child might end up withdrawing from her IRA, opening a Roth IRA may be a better choice. Money that goes into a Roth is taxed, but it's tax-free when it comes out. This means you can pull money that you put into a Roth out at any time, tax-free. You're only subject to tax and penalties on early withdrawals of any earnings. Furthermore, the unique nature of Roth accounts is usually beneficial for children because their at-retirement tax rates will almost certainly be higher than they are while the children are young.
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