When thinking of the best ways to save money for your child’s future, a Roth IRA rarely makes the list as a top retirement savings vehicle for kids. But it absolutely should!
Roth IRAs for kids provide an ideal investment account for their situation, because children have decades for their contributions to realize tax free growth.
And what’s more—these accounts offer considerable flexibility as well: The Roth IRA owner can withdraw contributions made into a Roth IRA tax- and penalty-free at any time.
If you want a tax-smart, flexible and impactful way to help a child invest for the future, consider opening a Roth IRA for kids. Roth IRAs are a type of individual retirement account that any adult can manage—parent, grandparent, aunt, uncle, family friend—on behalf of a minor making income.
This article will explore the custodial Roth IRA in depth, and answer any questions you may have about this financial product.
What is an IRA?
Young people often open IRAs with their first paychecks when they start working after school. Though, in truth, IRAs make excellent retirement investment vehicles for people of an even younger age.
Because of their young ages and the decades they have in front of them, children can take full advantage of the time ahead and leverage the power of compounding returns. What’s better—harnessing this financial superpower within a tax-advantaged savings vehicle.
The IRS only has one stipulation for an individual to contribute to an IRA: you need to have earned income. That doesn’t mean money received as financial gifts for babies and kids, nor from money you earn from chores, mind you.
To pass muster with the IRS, you have to earn taxable income as defined as “all the taxable income and wages you get from working…for someone who pays you or in a business you own.”
In this article, we’re going to explore the two types of IRAs for children and their respective benefits (traditional and Roth IRAs). We’ll also review how to open a Roth IRA for kids and contribute to it.
First, we need to learn more about investment accounts for kids in general, also called custodial accounts.
What is a Custodial Account?
When a minor has an investment account, it is usually in the name of the child’s parents or other guardian.
These types of accounts go by the name “custodial account” or guardian accounts because the custodian makes decisions on behalf of the beneficiary. In this case, a minor child.
Custodians can technically be anyone in the age of majority, but usually are the parent or guardian or even grandparent of a young person.
Having these accounts setup gives the custodian a chance to teach kids about money by saving and investing with real money they’ll one day own for themselves.
Custodians also maintain full control over the account until the beneficiary reaches the termination age, which is usually the same as the age of majority. This can be age 18, but also age 21 or 25, depending on the child’s state of residence.
When people make contributions into a custodial account, these become irrevocable gifts which now belong to the minor. Unlike 529 plans or other tax-advantaged savings accounts for kids, assets placed into a custodial account cannot be transferred to another.
Though, the money held in the account can go toward any number of expenses so long as they benefit the child.
Custodial accounts allow for maximum flexibility not only with how you spend the money (meaning it doesn’t need to be earmarked for one specific purpose as you would with a 529 plan going toward qualified educational expenses), but how you invest the funds for the benefit of the minor as well.
Custodial accounts in the United States are regulated by the Uniform Transfers to Minors Act (UTMA) and Universal Gifts to Minors Act (UGMA).
These two accounts have a few slight differences, but by and large, they have negligible differences and both allow you to invest as a Roth IRA.
What is a Custodial Roth IRA and What are the Rules?
The custodial IRA is a unique type of account that parents can open for their children.
In fact, this type of IRA doesn’t get offered by any financial institution which offers an IRA. These investment accounts are more niche than a standard IRA, allowing minors to start investing in their retirement.
A custodial IRA works like you’d expect, with the same rules as an IRA for adults:
→ There’s no age limit. If your baby lands a modeling gig and earns income, that money can go into a Roth IRA for kids. The hurdle to opening this type of account isn’t about age, rather, it’s income.
→ The child must have earned income. If your kid has earned income, they can open a custodial Roth IRA for kids. Be careful what qualifies as “earned income” however. That doesn’t mean allowance money or money received as gifts from friends and family. It can come from money earned through walking dogs, mowing lawns or performing other jobs for people outside of the family. The IRS allows money from a job or self-employment like baby-sitting. As an added incentive to get them to work, just because they must earn money to contribute to a Roth IRA doesn’t mean it has to be their money that gets contributed. In fact, your child can earn money from a summer job but you match their earnings as contributions to their Roth IRA for kids. The IRS doesn’t mind you doing this as an incentive so long as the amount contributed doesn’t exceed the child’s earned income.
→ There are contribution limits. The Roth IRA for kids contribution limit remains the same as Roth IRAs for adults: the lesser of $6,000 in 2021 ($7,000 if age 50 or older) or earned income. If your child baby-sits for some neighbors and earns $2,500 during the year, you can open a Roth IRA and contribute up to $2,500 into the account.
The slight difference here comes from needing a custodian to open and manage the account on the minor’s behalf.
The custodian oversees the account’s assets and how they are invested on behalf of the child. The account can hold investments in stocks, bonds, ETFs, mutual funds and other traditional financial assets.
Once the account beneficiary reaches the age of majority, ownership and control reverts to the beneficiary. At this point, the account owner can make decisions as he or she sees fit with how funds get invested, contributed or spent.
If the custodial IRA is a Roth IRA, the account owner can withdraw funds without penalty, unlike Traditional IRAs. However, if possible, it’s best that the funds remain in place and continue to benefit from investing early toward the child’s retirement many years down the road.
This way, the child’s money stays invested and can continue to grow through additional contributions and tax-free growth.
How to Open a Custodial Roth IRA for Kids
You have many different options for custodial accounts, including investing with a brokerage or bank. In most cases, you will want an investment account for your Roth IRA for kids, not just a simple bank account that earns interest.
Opening an investment account as a Roth IRA allows you to invest funds for the minor’s benefit, which can offer much higher returns than a savings account. So how do you decide which type of custodial Roth IRA to open for a child?
There is no black and white when it comes to “the best account,” but there are some considerations that can help you make a decision for what will work best for your individual financial situation.
- Fees. This is one of the most common considerations when choosing an account. Typically, custodial accounts have low or no fees if you are a customer with a brokerage firm. You may find some that charge trading commissions while others opt for a monthly or annual fee and act as a free stock trading app within the account. Some even offer free stocks for signing up in the form of shares or a sign up bonus. Consider your preferred model.
- Account minimums. Before opening an account, look into how much you’ll need to make as an initial deposit and the minimum account balance you’ll need to maintain.
- Investment options. You’ll also want to think about the types of investment options you’ll have available. Some custodial accounts offer a wide range of investment choices while others provide guardrails with fewer choices but simplified offerings.
- Investment support. You shouldn’t need to be an investment professional with a minimum of ten years on Wall Street to manage your investments. However, sometimes you want a little help beyond your own knowledge or a simplified menu of investment options suitable for most people’s goal of opening a Roth IRA for kids: long-term capital appreciation that grow tax free. Some choose to shortlist what you can buy, others offer research and resources to make your own stock picks, while others provide you free personal advice and support. Choose the online broker that meets your needs.
Now that you know what to look for in the best custodial Roth IRA accounts, read on to see our top picks available today.
1. M1 Finance: Best for Custodial IRAs and Financial Management for Kids
- Available: Sign up here
- Price: Free trades, $125 subscription to M1 Plus required for custodial account
If you wish to open a custodial Roth IRA for your child, the custodian of a child’s account (that’s you!) holds responsibility for taking on the management and control of an account’s assets until the termination age as determined by state law.
At which point, the assets and the account turn over to their possession.
Work with them while they’re young and looking to engage in teenage investing opportunities. This can provide valuable information and guidance as a way for teaching kids about money management.
You can use this to help them begin financial planning for the long-term.
Here’s how to do it: If your child is a minor (under 18 or 21 years old, depending on your state of residence), you will find many of the best stock investing apps for beginners will let you set up a custodial IRA.
One such app, M1 Finance, allows you to open a custodial Roth IRA through enrolling in their M1 Plus subscription. For the first three months, the company offers this as a free service ($31.75 value). Thereafter, it amounts to $125/year.
One way to invest for your child’s future is to automate investments by creating a child investment plan with this app. You can use the app to diversify your custodial IRA portfolio with index funds and stocks.
The banking app pays a high rate of interest and allows for cash back on purchases made with the debit card, perhaps negating the upfront fee you pay after your first year.
Going through separate services to establish these types of financial services can cost you upwards of $100/year, which is why having everything in one place makes it easier and cheaper.
Consider opening a custodial IRA through M1 Finance.
- Available: Call (800) 551-8631
- Price: Free trades on ETFs
This list wouldn’t be complete without the aptly-named company at the vanguard of fighting for the retail investor: Vanguard.
The company has long sought to lower investing costs for retail investors by offering market index investments for increasingly affordable rates.
Further, they want to make investing more accessible to the masses, including through a custodial Roth IRA.
In fact, John Bogle originated the idea of index fund investing and first offered them to retail investors as mutual funds and eventually exchange traded funds (ETFs).
These low-cost investments have saved retail investors billions of dollars over the years, allowing their returns to compound further.
While apps like Robinhood have slashed trading commissions to $0, Vanguard has led index fund investors to virtually $0 fund expenses as well. When combined, you invest for almost nothing.
Talk about a great accomplishment for the small investor looking to invest steadily over time.
If you’d like to open a custodial Roth IRA with Vanguard, you can’t do this online. You’ll need to call them at 800-551-8631 during normal business hours.
Once you open your account, you can purchase index funds as well as their all-in-one target date funds with a $1,000 minimum investment.
Finally, Vanguard also charges a $20 annual maintenance fee for accounts with small balances though it will waive this fee if you choose to sign up for their e-statement delivery service.
3. Charles Schwab
- Available: Download paper application or call
- Price: Free trades on ETFs
Charles Schwab also offers a custodial Roth IRA with no minimum balance and no annual maintenance fee. The broker has a number of other financial products to consider as a discount brokerage.
You can open a Schwab target date fund or invest in index funds.
4. Fidelity Investments
- Available: Sign up here
- Price: Free trades
You can open a custodial Roth IRA at Fidelity online, unlike with Vanguard or Schwab. Their accounts do not carry a minimum balance nor an annual maintenance fee.
Fidelity also offers several target date funds as well as low-cost index funds to consider.
Why a Custodial Roth IRA Might Be Right for Kids
Now that you know a bit more about if kids are eligible for Roth IRAs and where to open one, it might be a good idea to think about whether you should open one.
Roth IRAs are attractive to young investors because they add to the momentum of investing early. The key benefit is Roth IRAs provide tax free income at retirement when investments have gained value over time.
Some other considerations for whether opening a Roth IRA for your kids makes sense:
1. You Can Withdraw Contributions When You Need Them
Retirement accounts are strict about distributions; many charge a 10% penalty on money taken out before age 59½. That is a difficult characteristic for kids to master, as they are not well known for their ability to save now for when they need it later.
Delayed gratification isn’t an easy thing to adopt, especially at an early age when thinking about something decades away.
But here’s the catch with a Roth IRA: they’re different. Roth IRAs for kids let you withdraw contributions at any time and use them on anything from a dollhouse to a first real house.
In exchange for greater flexibility on how you can use contributions, Roth IRA earnings are subjected to stricter regulations. Earnings from investment choices are subject to taxes and/or penalties.
People have long debated the best options for saving for your kids’ future. For many parents, a Roth IRA falls somewhere between handing over cash and leaving their savings in place to grow tax-free.
2. More Time Means More Growth
There’s an old saying about investing that holds particularly true with Roth IRAs for kids: “It’s not timing the market but rather, time in the market.”
This illustrates a powerful phenomenon Albert Einstein called the most powerful force in the universe: compound interest.
It works like this: if given enough time, invested money turns into more money. Eventually, your earnings will generate earnings of their own. Sort of like how parents eventually turn into grandparents and see their families grow in size.
When most of us invest, we have 30 or 40 years to grow our retirement savings; if kids start even earlier on their investments and have more time, they can be surefire millionaires with enough discipline and diversified investing.
If you can manage to leave that account untapped and only a place for contributions over time, your kids could be looking at 50 or more years of investment growth, completely tax-free.
I get it- waiting that long isn’t the easiest sell on a child. I’ve found talking in numbers they can understand helps.
Use a simple example (illustrations usually help to seal the deal) to demonstrate the power of a one-time contribution of $6,000 in a Roth IRA—with no additional contributions at all. If you left it alone for 60 years and it earned 8% interest, it’d be worth over $600,000!
A return of almost 10,000%! And then imagine if they made consistent contributions and learned how to invest with small amounts of money.
3. Investing Beats Saving
That type of growth wouldn’t happen in a traditional savings account, the typical savings vehicle seen used by parents for their kids.
Even if you had received gifted stock in a custodial account without the same tax advantages, investing carries larger upside than money stored in a savings account.
Even more, an IRA allows your kids to learn about investing, how to research stocks, and experience the kind of growth a young person can enjoy for many years to come.
Savings accounts, on the other hand, pay a far lower, though safer, amount of interest. Rates have hovered between nothing and 2% in the last 10 years. The stock market has trounced that despite seeing two major market sell-offs during that same time.
But make no mistake, investing carries more risk than simply storing money in a savings account. Your kids could lose what they invest if not carefully chosen in things like stocks for kids or index funds.
Though held long enough and consistently, history tells us this isn’t likely to happen if you remain investing in a diversified portfolio.
4. Seize the Tax Advantages
You don’t get a tax deduction for contribution to a Roth IRA, but that shouldn’t matter all that much for kids. Instead, Roth accounts have you pay tax upfront and then see tax-free growth during the timespan of the account.
A Roth IRA is an excellent way to save for your child’s future when their time horizon is half a century and their tax rates are low.
In reality, the tax rates kids face are so low that they’d mostly avoid taxes on their contributions as well.
5. The Money Isn’t Just for Retirement
While a Roth IRA is technically a retirement account, the money you contribute doesn’t need to stay there forever.
If you practice Warren Buffett’s mentality, your ideal holding period is forever. That way, you allow your money to compound in perpetuity. But while that’s the goal, you should also know that contributions made to a Roth account don’t need to stay there.
In fact, contributions can be pulled out any time, for any reason. You can even lean on some loopholes to get your kid’s investment earnings out of the account before age 59½:
- If the Roth IRA is funded for five years, your child can withdraw up to $10,000 in earnings to buy a first-home without penalty or taxes.
- Roth IRA earnings can be used for qualified education expenses, such as college tuition. Earnings distributed will be taxed as income, but there will be no penalty.
Related Questions on Custodial Roth IRAs
Can a 10 Year Old Have a Roth IRA?
Yes. The cutoff for opening a Roth IRA isn’t based on age, rather income. A 10-year old can have a Roth IRA if he or she has earned income from a job or other self-employment.
Can You Open a Roth IRA for a Child?
Yes. Opening a Roth IRA for kids involves opening a custodial Roth IRA on their behalf. You can use the services highlighted above to open a Roth IRA account for a child.
Can Parents Contribute to a Roth IRA for a Child?
Yes. Parents can contribute to a Roth IRA up to the amount of earned income from the child. This means if the child earns $2,500 mowing lawns or babysitting during the year, parents can contribute up to $2,500 into the Roth IRA while allowing the child to keep the money they earned.
Likewise, a child can earn money and contribute this to the account. Further, they can choose to work but only contribute gift money received for a holiday, birthday or other celebration.
Does the Kid Need Earned Income to Contribute to a Child’s Roth IRA?
Yes. A child, nor any parent, guardian or loved one can contribute to a Child’s Roth IRA if the account owner doesn’t have earned income. The child’s income serves as the limiting factor for making contributions to a Roth IRA or Traditional IRA.
What is the Best Investment Account for a Child?
The best investment account for a child will vary depending on circumstance. If you need to save money for college, the best bet would be in a 529 plan or Coverdell Education Savings Account, not a retirement account like a Roth IRA.
Financial experts will tell you to consider your overall investment objective and then make the maximum contribution possible to achieve this desired outcome.
This can be to pay for qualified education expenses, earn tax free returns in a Roth retirement accounts, or even invest money through custodial brokerage accounts despite having fewer tax advantages with the investment earnings.
What Can You Invest In Inside a Roth IRA?
The type of custodial account you have matters, but not for traditional investments like individual stocks, exchange-traded funds (ETFs), mutual funds and the like.
If you’d like more investment options inside a Roth IRA, you’ll need to consider opening a UGMA account to allow for other assets. Through this custodial account type, you can have access to investments like property deeds, car titles, real estate and more.
However, these assets can’t exceed the annual contribution limit nor can these assets commingle with other non-retirement assets.
For example, you can’t have a piece of rental real estate which you live in nor which you maintain yourself.
Investing in these types of assets inside a Roth IRA can spell trouble for an investor not prepared for the risks involved nor with a clear understanding of the rules.
Can You Withdraw Money Penalty Free from a Roth IRA?
Yes. You don’t ever need to withdraw money from a Roth IRA because they don’t fall subject to required minimum distributions (RMDs). Though, in retirement, you can begin withdrawing money without any penalty as early as when you reach age 59½.
In fact, you can also start earlier if necessary. You can withdraw money from your traditional or Roth IRA before age 59½ without paying a 10% additional tax if the funds go toward paying for qualified higher education expenses for yourself, your spouse, your children or grandchildren in the year you make the withdrawal.
It is possible to avoid the 10% penalty for withdrawing your IRA funds before age 59½, and even though you will still need to pay income tax in most cases, having this cash on hand may come in handy.
Though, using these accounts to pay for your college tuition and fees can come with its own set of drawbacks:
- You take money away from your retirement assets — taking already limited funds you can’t contribute again unless you still work — so make sure you are well-funded outside of the IRA.
- If you withdraw money from a retirement account to pay for qualified education expenses, this could compromise eligibility for need-based financial aid in the year following withdrawal.
Does Self Employment Income Count as Taxable Income for an IRA?
Yes. The IRS states you need money paid from an employer or through self-employment to have sufficient earned income to contribute to an IRA.
This means money can come from dog walking, working at a restaurant or earning money from someone outside the family.