Roth IRAs for kids: What to know

A custodial Roth IRA can be an excellent way for children to learn about investing. It can also help build funds for retirement over many decades. 

As with most retirement and saving options, it pays to get begin early. While this may seem like an unconventional way of saving for children, the benefits are multiple. You can easily get started today by opening an account. 

Here's what to know and how to get started.

What is a custodial Roth IRA?

Roth IRAs can be ideal for children because contributions will grow tax-free for decades, far longer than when most people typically begin thinking about building a retirement nest egg. If your child is earning money at a job like babysitting, mowing lawns, or even an after-school job, they can use that earned income for a custodial Roth IRA.

Funds you deposit in a Roth IRA, a tax-advantaged retirement vehicle, can make real sense for kids. That's because children typically don't earn enough to warrant higher tax rates.  

"If we find out that the child has earned income, and they're either willing to part with some of that to open an account, or the parent or grandparent or guardian are willing to make the contributions on their behalf, we strongly encourage that they consider that," says Jeff Jones, director of financial planning at Longview Financial Advisers in Huntsville, Alabama. 

How does it work?

With a custodial Roth IRA, after-tax contributions are managed by a custodian - usually a parent, guardian or grandparent - until the child controls the account once they reach legal adulthood. In most states that's age 18, though in some it's as high as 21.

The same rules apply as for regular Roth IRAs, meaning an annual contribution limit of $6,000 for people under 50.

What qualifies a child for a custodial Roth IRA?

A child needs to earn income to qualify for a custodial Roth IRA. That can come from working formally for an employer that issues a W-2, or work like mowing the lawn or babysitting. Jones advises keeping good records and making sure the child is paid a "fair wage" for the work. 

"You cannot pay them exorbitant amounts. You can't have them mow the yard and say, 'I'm going to pay $200 to the yard,' unless it is very, very large. Or you can't pay them $1,000 to mow a small yard. It has to be an arm's-length fair wage," said Jones.

How much more will a child have at retirement with a custodial Roth IRA?

Say your 11-year-old earns $100 after taxes from babysitting and wants to invest it for retirement. You open a custodial Roth IRA on your child's behalf with that $100. 

If contributions continue at $100 monthly at an average annual return of 6%, the account will hold more than $327,000 when the child reaches 59 ½, the age when they can withdraw the funds tax-free.

if this sounds like something your child could benefit from then act now. You can easily get started today. 

Pros and cons of a custodial Roth IRA:

Pros:

• The child's money has decades to grow. 40 to 50 years of growth is an advantage. The earlier people start saving for retirement, the more money they'll have accumulated when they do retire.
• The custodian can "match" contributions up to any amount of earned income your child puts into a custodial Roth IRA within the annual limit. That means if your child puts in $50, you can add $50 for a total contribution of $100 (not more).
• It teaches young people money management skills early in life.

Cons: 

• Any contributions you make to a custodial Roth IRA become the child's money - you can't take it back if they act irresponsibly once they control the account. 
• The child won't have access to profits without penalties (with some exceptions) until they reach 59 ½ under current rules.
• Contributions can't exceed what the child contributes. For example, if your child earns $50 and contributes that to the custodial Roth IRA, you can only "match" an additional $50.
• Total contributions - including matching funds - can't exceed $6,000 annually.
• Unqualified withdrawals come with a 10% penalty before age 59 ½ and possible taxes.

How is it different from a traditional Roth IRA?

A custodial Roth IRA operates under many of the same rules as a regular Roth IRA. However, there are some key differences. 

Most importantly, your child must contribute earned income. That means you'll have to verify for the IRS that whatever taxes owed have been paid either through a W-2 form or careful records. 

In addition, the custodian can "match" the child's contribution. But the total annual contribution must not exceed that $6,000 limit. 

Can you use a custodial Roth IRA to save for college?

Yes - but it's not the best vehicle, Jones said. Experts recommend using other ways to save for college, including 529 plans or regular savings accounts. That's because of potential taxes and penalties tied to withdrawing earnings from a Roth IRA before 59 ½. 

Withdrawing from a custodial Roth IRA early also means there will be fewer funds to grow in the account once a withdrawal is made.

"A 529 may be a better fit, because if you're removing the contributions from the account, which you can do at any time, you're taking the growth engine out of the Roth IRA," Jones noted.

A custodial Roth IRA "should not be treated as a savings account. It truly needs to be treated as a retirement account," Jones added.

How to open a custodial Roth IRA

Some of the biggest brokerages online offer custodial Roth IRAs, like Fidelity, SoFi and Schwab, though the offering isn't ubiquitous. Shop around and compare. You may also want to check with a financial adviser to see which is right for the child for whom you want to open an account.