Thinking about your child's financial future? You may want to consider a custodial IRA or, more specifically, a custodial Roth IRA. This retirement account is typically set up by a parent or grandparent to help children with earned income start saving early and benefit from tax-free growth. Here's what you should know about this type of account and its potential financial benefits.
What Is a Custodial IRA?
This kind of individual retirement account (IRA) isn't complicated. It resembles one you would open for yourself and has the same contribution limits. The difference is that your child (or grandchild) is the "beneficial owner." That just means that someone else (you, as the custodian) is responsible for making all the decisions about how the money is invested and distributed until the child reaches the age of majority (18 in most states).
Custodial IRA Contribution Limits
As noted, the contribution limits are the same as those of an IRA that you might have for yourself. But that doesn't necessarily mean $6,000, which is the 2020 IRA contribution limit that most people think of. Another IRA contribution ceiling is the amount of one's earned income. While you, as an adult, may be earning more than $6,000, your child might not be. Earned income includes all taxable wages and income that you get from working and does not include gifts.
Potential Advantage of a Custodial Roth IRA
A custodial Roth IRA could make more sense than a non-Roth custodial IRA. The younger beneficial owner will have more time to grow their money and could earn more from their investments, which means that they could earn more tax-free income. Chances are that your child isn't earning enough to pay any income taxes, so a tax deduction that's potentially available for non-Roth IRA contributions may not be valuable. Though you don't get a tax deduction for Roth IRA contributions, you instead get tax-free treatment on your original contributions, and on the earnings on those contributions, when you withdraw the funds at retirement (as long as the requirements for a Roth IRA are met).
Teaching Your Child Good Financial Habits
A custodial IRA can help a child start saving early, but will they actually be willing to save some of what they've earned for a long-term goal like retirement? Some will and some won't. Even if the savings amounts are modest, helping a child develop the habit of saving regularly can be valuable. Plus, small savings today can help add up to a larger investment in the long-term.
It's never too early to start saving. Whether your child is putting money aside for retirement or another long-term goal, a custodial IRA could help them learn good financial habits and help their future financial well-being.
Individual Retirement Accounts (IRAs)