A custodial IRA is an IRA opened for a minor by a parent or guardian. A parent is free to open a traditional or Roth IRA for a child under 18. Not all institutions that offer IRAs will open custodial IRAs. As custodian, you must designate beneficiaries and choose investments for the minor.
A minor must have earned income to be eligible for a custodial IRA. The IRS defines earned income as wages, salaries, commissions, tips and self-employment income. If your child's only income is from investments or inheritances, you cannot open this type of account for him.
As of December 2012, for a minor, as for any IRA holder under 50, the annual contribution limit is $5,500. However, you can contribute no more to the custodial IRA than what the child earns that year. So, for example, if your child makes $2,000 from dancing in local musical theater productions, no more than $2,000 can be put in the account that year.
You have until the tax-filing deadline, typically April 15, to contribute to the custodial IRA. This can be helpful if you are not sure how much your child earned during the tax year. Internal Revenue Service Forms W-2 and 1099 should be mailed by January 31 each year. Tally up the total income amounts from any forms you receive to find out how much to put in the custodial IRA, not to exceed $5,500. If your child's earnings are from self-employment, keep careful records throughout the year of the work she performed and how much she earned when and from whom.
The money in the custodial IRA legally belongs to the child. The guardian cannot take funds out of the account. In addition, once the child reaches adulthood, he is at liberty to remove any or all of the assets. Ideally, the 10 percent penalty, along with the income tax liability associated with pre-age-59-1/2 traditional IRA withdrawals, will prove a deterrent. But a Roth IRA owner can withdraw contribution money at any time for any reason. A newly minted adult with spendthrift tendencies might end up raiding the IRA that you, as custodian, worked faithfully to build.
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