Roth IRAs and Children: Never Too Early to Save

You want your child or grandchild to be financially secure—not just now but throughout life. A great way to get a kid started on that path is through a Roth IRA. What is a Roth IRA? Contributions to a Roth Individual Retirement Account (IRA) do not qualify for an immediate income tax deduction; but a child is in a low tax bracket, so a tax deduction is not meaningful. Most important, qualified withdrawals from Roth IRAs are income-tax-free, and there is not a required minimum distribution at age 70 ½ like a traditional IRA, so a Roth IRA can grow tax-free for many years.

Yes, children can contribute to a Roth IRA, or you may do it on their behalf. Either way, by laying the groundwork of saving now, you can help them achieve a secure retirement. In the process they’ll get an early education in personal finance. With many adult Americans woefully illiterate about finance, your kid will be ahead of the pack before they even graduate from college.

How It Works

You can set up a Roth IRA as soon as your child or grandchild starts earning income. That money can be W-2 wages, or it can be self-employment income, like babysitting. An allowance does not count as earned income, but if you own a business, you can employ the child. The job must be age-appropriate, and the wages must be at the market rate.

A bonus to the Roth IRA is that the IRS doesn’t care who contributes to the account. It can be a child, a parent or a grandparent. So, for example, if you want to set up an agreement that for every dollar the child earns, you’ll put a dollar in their Roth IRA, that’s perfectly fine. The only requirement is that the total amount contributed to the account cannot exceed the amount the child earned.

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A couple of other points:

  • You can contribute as much as $5,500 to a Roth IRA annually. This amount is set by the IRS and will likely change over the years.
  • You can contribute as much as $400 in self-employment income without having to worry about paying Social Security or Medicare taxes. Make more than $400 and a tax return will need to be filed.
  • If a child does not receive a W-2 for the work they do, they need to keep records—which can be a great lesson in organization and responsibility. The records should include the type of work they did, when and who they did it for, and how much money they made.
  • You’ll likely be the custodian for the account until your child or grandchild reaches adulthood—age 18 or 21 depending on the state. After that, they’ll take control of the account.

Using the Roth IRA for Life’s Milestones

Roth IRAs offer flexibility that other retirement accounts don’t. Because they’re funded with after-tax dollars, the contributions can be withdrawn before retirement without penalty or taxes. Not so for the earnings—a nonqualified withdrawal before age 59 1/2 will incur taxes and a 10% penalty.

When it comes to buying a first-time home, the Roth can prove especially helpful since the purchase counts as a qualified withdrawal. So, in addition to contributions, a first-time homebuyer can tap into earnings of up to $10,000 as long as the account is at least five years old and the money is used for the down payment, closing costs and related expenses.

Flexibility like this makes Roth IRAs very attractive. Of course, if your child or grandchild can buy their first home without dipping into their account, all the better since it will leave more for retirement.

One final point: By getting a child saving early, the Roth IRA becomes an effective vehicle for transferring wealth from one generation to the next. Ultimately, your heirs may have a sizeable retirement savings before they even start their career.

As always, consult with a qualified tax advisor about your personal financial situation.