Do you remember how you earned and saved money as a kid?
Hazy images of lemonade stands, bake sales, and chipped glass piggy banks likely come to mind.
But there is another money-making avenue for your kids that’s worth exploring: a Roth IRA.
While Roth IRAs aren’t typically first on the list for child savings vehicles, they should be. Roth IRAs offer immense flexibility and a lifetime of growth and compounding potential.
So, how do you open a Roth IRA for your kids?
First, You’ll Need a Custodial Roth IRA
For your children to independently open a Roth IRA, they need to reach the age of maturity – usually between 18 and 21, depending on the state.
Until then, they’ll still need your signature.
Not all financial institutions offer custodial Roth IRAs, but Fidelity, Vanguard, and Schwab do. When choosing a financial institution, watch out for minimum balances, account maintenance fees, investment selections, and other factors that suit your needs.
As custodian, you maintain and control the IRA on your child’s behalf. This means, you manage all of the investment and distribution decisions and receive all account statements. Once your child reaches adulthood, the assets in the account will need to be transferred to a new account in their name.
Opening a custodial account with the same institution that houses your own Roth IRA or other investments could also add ease and continuity, while making account transfers much simpler and faster.
Once you find an institution you like, opening a custodial Roth IRA should be straightforward. All you’ll need is your and your child’s personal information (Social Security numbers, birthdates, etc.) and the money you’d like to invest, then you’re good to go!
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Investment Rules Still Apply
The good news is there are no age restrictions for contributing to a Roth IRA. Theoretically, a newborn could start accumulating retirement savings.
But there is a critical rule that poses a roadblock.
Contributing to a Roth IRA comes with one significant rule: the person contributing must have earned income.
What does that mean?
No, your child doesn’t need a 40-hour work week to qualify. The IRS defines earned income as taxable income and wages, whether through W-2 or self-employment opportunities. There are several ways to meet these requirements:
- Put your child on the payroll of your business and have them work part-time
- Use income from part-time summer jobs at any business like a restaurant, library, or store (as long as this income is properly reported)
- Seek other financial gigs like babysitting, dog walking, tutoring, etc.
Overall, your child just needs to earn income that’s reported to the IRS. If it’s self-employed income like mowing lawns or babysitting, that may mean paying self-employment taxes depending on how much they earn – which becomes another teachable money moment!
Can you contribute to the Roth IRA on their behalf?
Yes, you can help fund the account but you can’t contribute more than your child earns. Say they earn $1,000 as a summer camp counselor; you can match that $1,000 but not exceed it. Only contribute what you can afford – don’t derail your retirement or other investment endeavors just to bolster your child’s.
Roth IRAs have a $7,000 contribution limit for 2024, or the child’s total annual earned income, whichever number is less. This means if they make more than $3,000 a year, a child can only contribute up to $3,000.
Three Reasons a Roth IRA Could be Right for Kids
Roth IRA investment accounts are quite often beneficial. Though you make contributions with after-tax dollars, mitigating taxable income isn’t likely an issue your child needs to worry about yet. However, the earning potential and tax-free distributions are a big draw, especially at a young age.
1. You Can Withdraw Contributions Anytime, No Questions Asked
While the ultimate goal of a Roth IRA is accumulating money for retirement, it’s an incredibly flexible account that lets you withdraw contributions at any time, tax and penalty free.
Keep in mind that while your child can take out contributions without IRS consequences, the same isn’t true for earnings. Any investment earnings withdrawn for unqualified reasons result in income tax on the distribution and a 10% early withdrawal penalty.
Typically, qualified withdrawals meet two criteria:
- The account owner is 59 ½
- The account has been active for at least five years
But as your kids often learn in school, there are always exceptions to the rule.
2. Funds Can be Used for More than Retirement
It may be challenging to get your 14-year-old to save for retirement – that’s understandable. But Roth IRA funds aren’t just for the golden years your kids can’t even imagine, let alone want to save for.
There are other ways kids can use their Roth IRA funds as they mature. Below are some circumstances where your child can withdraw earnings before 59 ½:
- Earnings can be applied to qualified education expenses like tuition, fees, and books; while earnings for college costs are penalty free, they aren’t tax free; using Roth money for college also counts as income on FAFSA, which could conflict with future financial aid eligibility
- They can withdraw up to $10,000 for their first home purchase, both tax and penalty free
- For birth or adoption costs, the SECURE Act allows new parents to withdraw up to $5,000 from a Roth IRA penalty free (though not tax free)
3. It Exposes Kids to the Power of Compound Interest
The difference between saving and investing is a principle many people learn too late. While both have important places in your child’s financial life, introducing them to investing can demonstrate the growth potential of a long-term approach.
Getting your kids to buy into the value of long-term growth may be a challenge, especially when other spending is prioritized like buying a car, trips with friends, or looming college costs.
Try to involve them as much as possible in the process to show them firsthand how money invested wisely can help them achieve their goals.
A compound interest calculator can highlight how even a one-time $6,000 investment in a Roth IRA can skyrocket to nearly $120,000 in 50 years (with a 6% average return and monthly compounding).
And that’s just a one-time investment! Even contributing an extra $100 per month to that initial investment with the same parameters balloons the 50-year projection to over $500,000.
A traditional savings account, even a high-yield one, can hardly compete. The national average interest rate in 2024 for savings accounts is only 0.45%, according to the FDIC. Building a healthy cash reserve can help set your kids up for success, but developing solid investment habits early can better prepare them to reach goals down the road.
Convincing Kids to Save: Why Financial Education for Kids Matters
As parents, you teach your kids to budget, save, set goals, spend responsibly, and invest for the future. But readying kids to make consistent and healthy financial decisions as they grow up is a tall order, especially when nearly all the training falls on your shoulders.
Historically, much of the United States hasn’t adopted personal finance into traditional education curriculums. So your child’s financial knowledge mostly comes through watching and learning from you.
But this trend may be changing. In 2021, 25 states introduced new legislation to broaden access to personal finance in schools, and in 2022 numerous bills were passed that focused on adding financial literacy education requirements for graduating high school.
Financial literacy is a skill that guides your children through every stage of life – going to college, buying a house, their approach toward debt, and investing for their future. Study after study has demonstrated that teaching young kids about money equips them with the tools and confidence to make healthier long-term money choices.
Researchers for the National Endowment for Financial Education found that kids who engaged in personal finance courses were more likely to take out lower-cost loans for college and were less likely to rely on high-interest loans or credit cards.
A solid financial foundation can help children boost their credit scores, avoid accumulating unnecessary debt, and position themselves to better invest for their future.
All of these benefits come with time and consistency. Helping your kids invest some of their money in a Roth IRA early on is an excellent stepping stone toward a disciplined and fulfilling financial life.
Ready for a Roth IRA, Kids?
A Roth IRA could be instrumental to introducing your kids to investing, helping them establish healthy investment habits, and letting them find the drive and purpose to save for the future.
Would you like to explore trading in your child’s piggy bank for a Roth IRA? Reach out to an Abacus advisor today and let’s talk about your goals together.
Disclosure: This material is not intended to serve as personalized tax, legal, and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners, LLC is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining if any of the mentioned strategies are right for you.
