What is a custodial Roth IRA? (Open retirement account for minors)

What is a custodial Roth IRA?

A custodial Roth IRA is an individual retirement account for minors, managed by the custodian until the minor reaches legal age. The contributions are post-tax and the contributions and earnings are considered tax-free. Contributions can be withdrawn at any time, but earning withdrawals must be qualified. 

Imagine, setting up your child for early investment success. Your child has the flexibility to use the money for retirement, first home, education, or unreimbursed medical expenses.

Having a custodial Roth IRA can provide early financial security for your child.

Luckily for you, I’ll show you what a custodial Roth IRA is and how it compares to a traditional IRA. I’ll show you who can open a Roth IRA, make contributions, and rules which apply. Lastly, I’ll show you where you can open a Roth IRA for your kid.

21-121 - What is a custodial Roth IRA (Open retirement account for minors)

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What is a custodial Roth IRA?

A custodial Roth IRA is an individual retirement account for your child where contributions have already been taxed. The earnings and contributions grow tax-free and can be used to pay for the child’s first home or education expenses. You are the responsible adult or custodian who manages the IRA until the child is no longer considered a minor.

Roth IRAs have a contribution limit of $6,000 per year or $7,000 for individuals over 50. Most parents contribute to the Roth IRA for their child to assist with future retirement, education, or home downpayments.

Contributions to a Roth IRA are considered to be already taxed. Therefore, if you deposited $5,000 into a Roth IRA then you can withdraw that $5k anytime, tax and penalty free.

Earnings to a Roth IRA grow tax free. A Roth IRA that yields $50,000 in investment returns can be withdrawn without paying any tax.

However, earnings are subject to a 10% penalty if you are withdrawing outside of a qualified exception. A Roth IRA must be open for five years before you can withdraw any earnings. To withdraw your earnings without penalty, you must be either:

  1. Be 59.5 years old 
  2. Be permanently disabled 
  3. Withdrawn by a beneficiary after your death
  4. Use for a qualifying expense, such as education or first home
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Which is better: a Roth IRA or Traditional IRA?

The primary difference between a Roth and Traditional IRA is when you pay taxes. A Traditional IRA allows you to use pre-tax money for investing, but taxes are due upon withdrawal on contributions and earnings. A Roth IRA considers contributions and earnings post-tax and can be withdrawn anytime, but earnings must be a qualified withdrawal.

A Roth IRA is better than a Traditional IRA for children because of the flexibility. You can use a Roth IRA for important milestones, such as your child’s first home. The Roth IRA can also be a safety net and used for paying medical bills that were not reimbursed.

Setting up a Roth IRA now can set your child up for retirement. Your child will already be familiar with investing if you set up a custodial Roth IRA in their teenage years. Therefore, your child is likely to continue investing after they get their first job.

Let’s assume your child has $18,000 in their Roth IRA by the time they turn 21. Your child then contributes the maximum of $6,000 every year until they’re 60 years old. At a 7% return on investment, your child would have $1.5 million just by maxing out their Roth.

However, you have to remember that inflation will reduce the purchasing power of the retirement account. Assuming the child is 21 in the year 2021, the child will be 60 in the year 2060. In 2060, having $1.5 million would be like having $695k in 2021.

Can I open a custodial Roth IRA for my child?

Anyone can set up a custodial Roth IRA for any minor and manage it until the child turns 18 (or 21 depending on residence). Your child must have earned income and can contribute the lesser of $6,000 or total compensation. However, the IRS does not require tax filings for earnings under the standard deduction ($12,550 in 2021).

How much money do you need to start a Roth IRA?

There is no minimum amount of money needed to start a Roth IRA. You will need to have initial money to deposit into your Roth IRA account. You cannot contribute more than the maximum contribution limit, which is $6,000 in 2021.

What are the custodial Roth IRA requirements?

Your income level must be below the modified adjusted gross income levels set by the IRS and your child must have earned income. Having income levels higher than the modified adjusted gross income can reduce or prevent you from contributing. You can contribute the lesser of $6,000 or your child’s total compensation.

Contribution limits are set if you earn more than $122k (single filers) or $193k (married). Therefore, most individuals will be able to contribute to a Roth IRA.

Be aware that the child will take full custody of the account upon reaching legal age. In most states, the legal age is 18, but it can be 21 in some states. All funds will be the property of the child at the legal age, not the parent or custodian!

Who can contribute to a custodial Roth IRA?

Anyone can contribute to a custodial Roth IRA for a child. The child must have had some form of earned income in order to be eligible for contributing. Total contributions to the Roth IRA may not exceed $6,000 in 2021.

Can parents contribute to a Roth IRA for a child?

Parents can contribute to a custodial Roth IRA for a child.

How much can you contribute to a custodial Roth IRA?

Custodial Roth IRA contribution limits for 2021 is $6,000 or children’s earned income up to $6,000, whichever is lesser. Therefore, a child who earned $2,000 can contribute the full $2,000 to their Roth IRA.

Where can you open a custodial Roth IRA?

You can open a custodial Roth IRA through brokerages like Charles Schwab, Fidelity, and Vanguard. Most brokerages have a web page specifically for opening a custodial Roth IRA. However, some brokerages require you to call customer support to open an account.

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Summary: Custodial Roth IRA

As you can see, opening a custodial Roth IRA can be a good move in planning your child’s future. The contributions are already taxed and can be used for education, house down payments, or unreimbursed medical expenses. Your child gains control over the account at 18 and can continue to save for retirement.

Roth IRA contributions are currently limited to $6,000 per year or $7,000 for people 50 or older. Contributions can be withdrawn at any time, without penalty or tax.

Roth IRA earnings can be withdrawn tax free as well. However, withdrawals of earnings need to be qualified to avoid a 10% penalty. Qualified withdrawals on earnings include being 59.5, being permanently disabled, beneficiary withdrawals on death, or educational or first home expenses.

Anyone can open a Roth IRA for a child, but the child will need to have earned income. Anyone can help contribute to the Roth IRA as well.

Open a custodial Roth IRA by using a brokerage like Charles Schwab, Fidelity, or Vanguard. The process is similar to opening up any retirement or brokerage account.