Benefits of ROTH IRAs for Children

June 30, 2023

Do you have a child or grandchild that you gift money to?  Does the child have any work where they have “earned” income?

If so, perhaps you might want to consider gifting to their retirement by contributing to a Roth IRA.

A Roth IRA is a type of retirement account that offers tax advantages for individuals.  While the primary purpose of a Roth IRA is to save for retirement, it can also be a valuable financial tool for children, allowing them to start saving early and potentially benefit from long-term growth.

Here are some key points to consider regarding ROTH IRAs for kids:

Eligibility:  To contribute to a Roth IRA, the child must have earned income.  This can come from sources such as a part-time job, babysitting, or mowing lawns.  The earned income must be reported on the child’s tax return. Ideally your child should have a W-2 or a Form 1099 to show evidence of the earned income. In some instances this may not be possible so it’s important to keep records for the type of work, when the work was done, who the work was done for and how much your child was paid.

Contribution Limits:  The maximum contribution limit for a Roth IRA is based on the child’s earned income or the annual limit set by the IRS, whichever is lower.  As of 2023, the annual contribution limit is $6,500.

Tax Advantages:  Contributions to a Roth IRA are made with after-tax money, meaning they are not tax-deductible.  However, the growth and withdrawals from the account can be tax-free in retirement, provided certain conditions are met. This can be particularly advantageous for children, as they are likely to be in a lower tax bracket, if any bracket, during their early earning years and therefore do not need a tax deduction. Unlike contributing to a Traditional  IRA where the contribution is tax deductible but all the assets would be taxed upon withdrawal.

Parental Involvement:  A child cannot open a Roth IRA account on their own.  A parent or legal guardian must open a custodial Roth IRA account on behalf of the child.  The parent or guardian will manage the account until the child reaches the age of majority, typically 18 or 21, depending on the state.

Investment options:  The funds within a Roth IRA can be invested in various assets such as stocks, bonds, mutual funds, or exchange traded funds (ETFs).  The specific investment choices will depend on the brokerage firm or financial institution where the account is held.

Early Withdrawal Rules:  While the primary purpose of a Roth IRA is for retirement savings, there are provisions that allow for penalty-free early withdrawals of contributions (not earnings).  However, it’s generally advisable to keep the funds in the account for long-term growth and let them accumulate until retirement age.

Long Term Savings Potential:  By starting early, kids have more time for their investments to grow, potentially accumulating substantial wealth by the time they retire.

As an example, if a child contributes $2,000 to a Roth IRA every year for 50 years and the average return of the portfolio is 8%, the overall contribution of $100,000 would potentially grow to over $1.3 Million of Tax Free Money.

Bottom line is that ROTH IRAs are beneficial for kids as they have decades for their contributions to grow tax-free.