How Custodial Roth IRAs are a Wise Investment in Your Child’s Future
The flexibility of a Custodial account with the tax benefits of a Roth IRA
Custodial Roth IRAs have become a popular choice for parents looking to help their children build up their savings. These accounts offer a combination of tax benefits and flexibility, allowing young people to start saving and investing early.
Although when it comes to selecting the most suitable savings vehicle for your children, parents have a number of options, such as traditional Custodial accounts and 529 Plans. Here’s what to know when choosing between these accounts.
Key Takeaways
- Traditional Custodial accounts offer a high degree of flexibility and a wide range of investment options. They are set up for the benefit of a beneficiary, by a responsible adult.
- 529 Plans are specifically designed to provide tax-advantaged savings for qualified education expenses.
- A Custodial Roth IRA is opened for a minor with earned income and provides tax-free growth and tax free withdrawals in the future.
- Roth IRAs can be an excellent choice for children since they offer the advantage of many years for contributions to grow tax-free.
Traditional Custodial accounts
Custodial accounts, also known as UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) accounts, were created under state laws to hold gifts or transfers of funds to a minor.
Typically, custodial brokerage accounts are opened by parents or grandparents who want to save for a child’s future or make financial gifts to the child. They’re often used by affluent families where parents or grandparents want to remove money from their taxable estates by gifting it to the younger generation.
The assets, both its principle and any earnings, become the property of the minor when they reach the age of majority, typically between 18 to 25. Once you deposit funds into a custodial account under either of these laws, you cannot access or withdraw the money, as it becomes the property of the minor recipient.
There are no contribution limits to Custodial accounts. However, the annual gift tax exclusion applies in the same way it does to other types of gifts.
What is a Custodial Roth IRA?
A Custodial Roth IRA is a tax-advantaged retirement account in which a parent, grandparent or any other adult opens on behalf of a minor.
Contributions to a custodial Roth IRA are made after tax, unlike some retirement account contributions. They aren’t tax deductible and they don’t reduce your taxable income in the year you make them.
The unique advantage of a Roth IRA is that it is funded with after-tax dollars, meaning that the account holder can withdraw the contributions and earnings tax-free after they reach 59 1/2 years old, and have held the account for at least five years. This feature makes it an attractive option for long-term growth, as well as a tax-efficient way to transfer wealth later on.
Minors generally cannot open brokerage accounts in their own name until they are 18. This is why a Custodial Roth IRA requires an adult to serve as the custodian. The custodian maintains control of the child’s Roth IRA, including decisions about contributions, investments, and distributions.
Age of Majority and Age of Termination
The age of majority and the age of termination are two different aspects that come into play in with Custodial Roth IRAs, where the account will need to be converted to a regular Roth IRA in their own name.
The age of majority is the age at which an individual is legally considered an adult and can sign contracts. This age is often 18, but it can vary depending on the state. When a child reaches the age of majority, they have the option to take control of the Custodial Roth IRA. But this transfer of control can only happen with the consent of the custodian. This means that even though the child is legally an adult, they cannot take control of the account on their own without the custodian’s agreement.
On the other hand, the age of termination is the age at which the custodian is legally required to transfer control of the account to the child. This age is usually 21, but it can be up to 25 depending on the state. When a child reaches the age of termination, they can remove the custodian from the account and take full control, regardless of whether the custodian consents.
Income Restrictions
A Custodial Roth IRA can be opened for a minor who has earned income during the year. This income can come from formal employment or self-employment. Income earned from babysitting, performing, working in businesses owned by their parents, or other freelance work can qualify a minor for Roth IRA contributions.
The maximum annual contribution in 2023 is $6,500, or the total of a child’s earned income for the year — whichever is less. In 2024, the maximum annual contribution limit is $7,000. For example, if your daughter earned $2,000 during a summer job, she could contribute up to $2,000 to her Custodial Roth IRA.
Withdrawal Rules
A Roth IRA is designed as a retirement savings account, and the account holder is generally required to be at least 59 1/2 years old to make withdrawals from the account without incurring penalties. Also, the Roth IRA account must have been established for a minimum of five years from the date of the first contribution. If these conditions are not met, a 10% penalty is applied to early withdrawals.
There are some exceptions that allow your child to access the investment earnings before reaching age 59 1/2:
- First-time homebuyer exception: After your child’s Roth IRA has been funded for five years, they can withdraw up to $10,000 in earnings to purchase their first home. This withdrawal is tax-free and penalty-free.
- Qualified education expenses: Roth IRA earnings can be used to cover qualified education expenses, such as tuition, fees, and books at eligible educational institutions. While these withdrawals will be taxed as income, they won’t be subject to any additional penalties.
Investment Options
The funds in a Custodial Roth IRA can be invested in various assets just as with any Roth IRA. Investments can include stocks, bonds, mutual funds, and ETFs. Typically, the investment strategy should be tailored to the child’s age, risk tolerance, and investment goals.
How Do I Invest for a Custodial Roth IRA Account?
For younger children, you might opt for a more aggressive investment strategy with a higher proportion of stocks, which have the potential for higher returns over the long term. Low-cost ETFs or mutual funds that track the entire S&P 500 or the entire U.S. stock market is generally a good choice for your child’s investment portfolio.
It’s also worth considering target-date funds, which automatically adjusts the investment’s asset mix based on a specified target date (typically the year the child will turn 18). The investment strategy can always be adjusted as the child ages or as their investment goals change.
Which Account Is Right For Your Child?
Deciding between a Custodial Roth IRA, Custodial IRA account, and a 529 Plan will depend on several considerations. These include whether your child has earned income, your annual savings capacity, your child’s savings and educational goals, the potential tax benefits, the investment choices allowed by these savings vehicles, and additional features offered by each.
Custodial accounts offer flexibility with the use of funds, variety of investments, and unlike 529 plans, there are no penalties if the funds aren’t used for qualified educational expenses.
A 529 Plan is considered a good choice for college savings due to its tax benefits and large contribution limits. If you’re sure the money you’re saving will be used for education expenses, a 529 plan may be a good choice.
A Custodial Roth IRA is a great option if the child has earned income as it combines the flexibility of traditional Custodial accounts with the tax benefits of Roth IRAs. It also has the advantage of the beneficiary not needing to pay income tax on any of the withdrawals they make in future decades.
Another added benefit is that a Custodial Roth IRA can be a financial tool that can provide your children with a head start in understanding the value of saving and investing.
I’ve also written about Maximize Retirement Savings with A Mega Backdoor Roth IRA and Roth 401(k) vs. Roth IRA — Which Suits Your Retirement Plan?
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This article is not intended as specific financial advice. You should conduct your own research before making any financial decisions and consult with a professional advisor.