The Longest-Lasting Gift: A Custodial Roth IRA for Your Child
Executive Summary:
While you can certainly buy your child that pair of sneakers they've been eyeing, consider introducing them to an even more valuable gift: a Custodial Roth IRA. This powerful financial tool offers both immediate and long-term benefits, providing significant tax advantages and instilling important lessons about saving and investing. A Roth IRA can be a transformative gift, shaping your child’s financial future in meaningful ways.
The Value of a Roth IRA
A Roth IRA is more than just a retirement savings account; it’s an educational tool that introduces children to the principles of saving and investing from an early age. To open a Roth IRA for your child, they must have earned income, such as from summer jobs or part-time work. For example, if your child earns $1,000 in gross income mowing the neighborhood's lawns, they can contribute up to that amount into their Roth IRA, with a maximum annual limit of $7,000 for 2024. It’s important to note that this income must be reported on their tax return.
Pointer: To encourage saving, you can implement a matching contribution where you, as the parent, match a portion of their contributions, if it stays within their annual contribution limit based on their earned income. For example, if your child earns $1,000 mowing lawns and you match 50% of their contribution, the child will contribute $500, and you would add another $500 to their Roth IRA. This would reach their maximum contribution for the year based on their earned income. Additionally, this contribution would be within the allowable gift exclusion of $18,000 per recipient for 2024. Note that this annual exclusion applies to each gift recipient individually.
Flexibility and Long-Term Benefits
One of the Roth IRA’s greatest advantages is its flexibility. Contributions can be withdrawn at any time without tax or penalty, making it a useful tool for managing unexpected expenses or preparing for future needs, such as purchasing a car. This is separate on the earnings made within their Roth IRA. Earnings are subject to 10% penalty before the age of 59.5. But there are exemptions - after the Roth IRA has been open for at least five years, your child can withdraw up to $10,000 in earnings tax free for a first-time home purchase without facing taxes or penalties.
To maximize these benefits and avoid the 10% early withdrawal penalty on earnings, follow these guidelines:
Age Requirement: Withdrawals of earnings should be made after reaching age 59½ to avoid penalties.
Holding Period: Ensure the Roth IRA has been open for at least five years before withdrawing earnings to avoid taxes and penalties.
Here is a full list for qualified exemptions on earnings.
Note on Withdrawals and Financial Aid
While Roth IRA contributions can be withdrawn tax-free at any time, withdrawals are considered untaxed income on the following year’s Free Application for Federal Student Aid (FAFSA), which could potentially reduce eligibility for need-based financial aid. Roth IRA assets themselves are not reported on the FAFSA and are excluded from asset calculations, but any distributions taken are counted as income in the year they are withdrawn.
The Power of Compound Interest
One of the most impactful benefits of a Roth IRA is the power of compound interest over time. Starting early allows your child to benefit from decades of tax-free growth. With 50-60 years of compounding, even modest contributions can grow significantly, providing a substantial nest egg for retirement. For instance, a $1,000 investment growing at an average annual return of 7% could grow to over $14,000 over 50 years. This potential for long-term growth underscores why a Custodial Roth IRA can be one of the most impactful gifts you can give your child.
A Custodial Roth IRA offers not only a valuable financial tool but also an opportunity to instill important lessons about saving, investing, and financial planning. By introducing your child to this powerful gift, you’re not just providing them with financial benefits but also equipping them with knowledge that will serve them well throughout their lives.
Addendum: A custodial Roth is eligible to switch to a normal Roth IRA at the age of majority in your state (usually 18 or 21). Check your local state laws to see what age is applicable to your situation.
Disclosure: The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Advisor. IFP and Pointer Financial Group are not affiliated.