Contributing to a Roth IRA is an extremely efficient way to save for retirement. The earlier a client starts making contributions, the more time there is for the savings to grow tax free. Wouldn’t it be great if younger investors could take advantage of a Roth IRA and start saving in their teenage years? The good news: They can. Depending on the circumstances, your clients may have children who are eligible to open a minor-owned Roth IRA. Here’s what you should know.
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Opening a Minor-Owned Roth IRA
The registration process varies from provider to provider, but the account is typically opened as a custodial Roth IRA. The child is the account owner, with an adult serving as the custodian. Contributions are reported to the IRS under the minor’s social security number, but the custodian is the individual authorized to act on the account. The custodian is usually (but not always) a parent. Providers may have additional requirements if someone other than a parent serves as the custodian.
There is no age requirement to make a Roth contribution—the same eligibility rules apply to both adults and minors. Once the child reaches the age of majority (either 18 or 21, depending on the state), the funds can be transferred into a Roth IRA in the adult child’s name. Subsequently, the adult child is authorized to manage the account.
The Determining Factor: Income
The minor must have earned income to make a Roth contribution. A child with a part-time job after school or summer employment is a prime candidate.
Ideally, the minor’s employer will issue a W-2 for the work performed. But what if the minor isn’t employed with a company and instead mows lawns, shovels snow, or babysits? Is the money he or she receives considered earned income? The answer is, maybe. It’s up to your clients to document that their son or daughter received earned income and that the amount is reasonable. (A parent could not pay a child $1,000 for two hours’ worth of babysitting.) Recommend that your clients consult with a tax advisor or CPA if they’re unsure whether their child’s work can be substantiated as earned income and if the pay is reasonable.
Funding the Roth
The total amount minors can contribute for a year is $6,000 (for 2019) or 100 percent of their earned income—whichever is less. A common question clients ask is if the contribution must be made with the actual income earned by the child or if it can be funded with a gift from a family member. Either option works. Regardless of how the account is funded, however, the child must always have earned income to qualify for a Roth contribution.
Keep in mind that the IRS imposes limits on tax-free gifts. If a minor-owned Roth IRA is funded as a gift, encourage your clients to consult with a tax advisor to ensure that they follow IRS gift tax rules.
The Benefits of Minor-Owned Roth IRAs
Five years after the first contribution is made to a Roth IRA, there are several different options for withdrawing funds.
Retirement funding. Once the account owner reaches age 59½, all funds in the Roth IRA can be withdrawn tax and penalty free. For example, let’s assume your client’s 15-year-old son or daughter makes a $6,000 contribution and never contributes again. Assuming a 6 percent rate of return compounded annually, that contribution will be worth $80,216.33 when the individual reaches 59½ and $110,520 at age 65. That beats a normal savings account earning minimal interest. Please note: This scenario is hypothetical, and future rates of return can’t be predicted with certainty.
First-time home purchase. The account owner can make tax- and penalty-free withdrawals of up to $10,000 to pay for costs associated with purchasing his or her first home. (Consult IRS Publication 590-B for details on what expenses are deemed qualified home acquisition costs.)
Education expenses. Account owners can make withdrawals to pay for qualified education expenses, including college tuition, books, and supplies. Distributions of earnings will not be subject to the early withdrawal penalty but will be subject to ordinary income taxes. (Consult IRS Publication 590-B for details on what expenses are deemed qualified education costs.)
Emergencies. The minor can also make tax- and penalty-free withdrawals in an emergency. In this case, the five-year waiting period after the account has been opened does not apply. Contributions can be withdrawn at any time and at any age. Withdrawals of earnings, however, would be subject to taxes and penalties if five years have not passed since account opening and the account owner is younger than 59½.
In Pursuit of Financial Independence
It’s unrealistic to expect teens to use their hard-earned money to save for retirement rather than buy what they want. But providing the option of a minor-owned Roth IRA is a way for your clients to instill in their children the importance of setting money aside for the future. You might even suggest your clients match their child’s contribution, which can provide further incentive for kids to save—and ensure that the next generation gets a head start in pursuing financial independence.
Do you have clients considering opening a Roth IRA for their children? What about those who are reaping the benefits of one? What have you found to be the biggest benefit of a minor-owned Roth IRA?