IRAs allow you to invest money shielded from current income taxes. The sooner you begin contributing to your IRA, the more time your investments can grow tax-free. In a traditional IRA, contributions are tax-deductible, and distributions are taxed as ordinary income. However, a Roth custodial IRA account is better suited for a child due to its unique tax benefits.
A custodial IRA is a retirement account opened by a minor and managed by an adult IRA custodian for the child’s benefit.
Roth IRA for Minors
A Roth IRA accepts post-tax contributions, meaning you don’t get a tax deduction on the money you contribute. This is usually not a problem for children, who typically have incomes that are low enough to incur little or no income tax. In return, distributions are tax-free if you follow the rules. Many mutual funds, banks and brokerages offer custodial IRAs to minors under 18 years of age. To open the account, you and the child will have to provide Social Security numbers and other identification, fill out a custodial account agreement and designate a beneficiary. As the custodian, you control contributions, investments and distributions, and you receive the IRA account statements from the account trustee. If you distribute funds from a custodial IRA for the benefit of the child, you cannot later demand reimbursement from the child.
Custodial IRA Contribution Rules
Parents and others cannot contribute to a Roth IRA for a child. As of 2019, the child’s contributions to an IRA are limited to the lesser of their earnings or $6,000. The limit is $7,000 once the account owner reaches age 50. Only the child’s earnings can be contributed to an IRA. For example, if a minor earns $2,000 from mowing lawns and receives a $1,000 gift from a grandparent, the minor can contribute up to $2,000 to the custodial IRA, because the grandparent’s gift isn’t earnings. Roth contributions have certain limits for high-income earners that generally are irrelevant for minors.
Custodial IRA Distribution Rules
Contributions to a Roth IRA can be distributed at any time, tax-free. Earnings are subject to ordinary income taxes and a 10 percent penalty if distributed within the five-year period starting with the year of the initial contribution. In general, any distribution of earnings is taxed and penalized if it occurs before reaching age 59 1/2, unless the account owner qualifies for an exception to the 10 percent penalty. The list of exceptions includes:
- You incur a total and permanent disability.
- You pay qualified higher education expenses.
- You have substantial unreimbursed medical expenses.
- You buy, build or rebuild your first home.
- Your IRA is levied by the IRS.
- You are a qualified reservist.
- You pay medical insurance premiums while unemployed.
- You are the IRA beneficiary of a person who dies.
There are no required minimum distributions for a Roth IRA, and you can contribute at any age. Special distribution rules apply to custodial IRAs:
- The custodian can withdraw money only for the exclusive benefit of the minor.
- The minor takes sole possession of the IRA assets upon reaching the age of majority (18 or 21, depending on the state), and can transfer the assets to her own independent account.
The Benefits of a Custodial IRA
A long time horizon is a strong positive factor for successfully accumulating a sizeable retirement nest egg. According to Fidelity, a custodial Roth IRA opened by a 15-year-old minor who contributes the maximum amount each year and earns an average annual return of 7 percent will be worth $3,439,705 at age 70. Waiting until age 25 reduces the value to $1,732,000. The nest-egg shrinks to $863,889 or $422,586 for accounts beginning at age 35 or 45, respectively. The financial advantage of a custodial IRA is easier to quantify than the emotional benefits associated with thrift and long-term planning, but the latter might be no less important.
Challenges of a Custodial IRA
One problem many parents confront when their child turns 18 is persuading the child to leave the funds in the custodial IRA undisturbed and to continue to contribute part of her earnings each year. After all, an 18-year-old has many ways to spend money and might not have the maturity to practice self-control. Some parents have found it expedient to provide a de-facto matching fund for a child’s IRA contribution during the first few years after the age of majority. For example, if a child earns $4,000 in the year of her 18th birthday, parents can gift the child $4,000 without triggering gift tax (as of 2019, the federal gift tax exclusion is $15,000), allowing the child to contribute her full earnings to her IRA painlessly.
The Long Time Horizon
When young people open and contribute to a custodial IRA, they take advantage of a long investment time horizon that can help them withstand the volatility of stocks and other assets. No one can reliably predict the stock market year after year, which means a certain amount risk is unavoidable. There are the risks of losing investment value due to a bear market, making poor selections or incorrectly timing the market. However, with a 50-year or longer time horizon, investors can take advantage of long-term trends that dominate over short-term volatility. Stocks naturally trend upward due to growing economic activity driven by population dynamics, technology and many other factors.
Occasional reversals, including recessions and depressions, have always been overcome after the passage of time. Young people have many years to recover from down markets, poor stock choices, bad timing and whatever other factors contribute to losses. A custodial Roth IRA reinforces patience by providing sheltered profits while penalizing early withdrawals. Furthermore, investors do not need to be sophisticated to profit handsomely from long-term investments. That’s because there are many helpful strategies available to even the most inexperienced investors, including:
- Instant diversification: Investors can acquire a diversified portfolio easily through the purchase of mutual funds and exchange-traded funds (ETFs). These are baskets of stocks, bonds and other assets that often consist of hundreds or thousands of different securities. Diversification reduces risk by limiting the impact of random individual losses since each position is relatively small. Mutual funds and ETFs are professionally managed according to the fund’s investment objectives.
- Index funds: Index mutual funds and ETFs mimic the performance of well-known market indices, such as the S&P 500 stock index. Index funds not only provide diversification but also have very low costs, since the funds are passively managed. Over a 50-year horizon, this can save tens of thousands of dollars in fees, and it reduces trading costs to a minimum.
- Horizon funds: Horizon mutual funds are managed with a target date in mind. For example, a 2070 fund anticipates that shareholders will not retire until that year, and that allows the fund managers to allocate shareholder money to assets in an intelligent way. With such a long horizon, fund managers can, in the early years, allocate most investor money to risky assets, like stocks and futures. Over time, fund managers rebalance the portfolios toward lower-risk assets, like bonds and money market instruments, to help preserve the accumulated wealth of shareholders. At the target date, the portfolio is risk-averse, befitting the perceived needs of many retirees.