Funding a Custodial Roth IRA for Your Kids
We’re all familiar with the Roth IRA, an after-tax individual retirement account that permits both earnings and withdrawals (after age 59 ½ of course) to be completely tax-free. This tax-advantaged investment vehicle is not exclusive to those over the age of 18, in fact a Custodial Roth IRA exists that allows parents to contribute on behalf of their children, assuming the child has qualifying income.
While this investment was created as a retirement savings vehicle, contribution amounts can be withdrawn tax and penalty-free at any time! Additionally, certain events, such as a first-time home purchase, college expenses, and even birth or adoption expenses allow for both contributions and earnings to be withdrawn tax and penalty-free so long as certain requirements are met. These features make a Roth IRA a great “start your life” fund for parents that are eager to set their kids up for success.
Roth IRA vs Traditional IRA
Since most kids don’t earn enough income to benefit from the up-front tax deduction associated with a Traditional IRA, it might make sense for your children to put their hard-earned income away in a Roth IRA. Tax-free future income is the biggest benefit of saving in a Roth IRA. We want to highlight the long-term after-tax benefits that are so prevalent in this retirement savings vehicle. In the example below, we have illustrated the after-tax benefit of adding money to a Roth IRA for your 14-year-old for five consecutive years. We assume we can earn a 7% per year return and the child is in the 10% tax bracket today compared to a modest 24% tax bracket in the future when they start drawing funds in retirement.
In comparing identical contributions from ages 14-18 in the amount of $6,500 per year with equal market performance until the age of 60, your child would have $171,427.09 more on an after-tax basis than if this money would have stayed in a Traditional IRA.
Regulations on Your Custodial Roth IRA Contributions
A parent or other adult must open the Custodial Roth IRA on the child's behalf. Not all online brokerage firms or banks offer custodial IRAs, so you’ll need to check with your advisor to see if you can set one up.
Kids of any age can contribute to a Roth IRA so long as they have earned income. Allowance does not count as income, contributions require W-2 or 1099 income. While the 2023 contribution limit is $6,500 and they may contribute that, they may only contribute up to the amount of earned income they show on their W-2 or 1099. In other words, if a W-2 is received for the current year that shows earned income, you can contribute all of this income to the Custodial Roth IRA up to $6,500 for 2023.
Taxes for Working Kids – They Can Contribute to a Roth IRA Even if They Don’t File a Tax Return
Generally speaking, if your child is considered a dependent and they do not earn more than the standard deduction, they won’t need to file a separate tax return on earned income. Taxes do become increasingly trickier if the child is claiming income from Self-Employment jobs, such as mowing lawns or babysitting. With a self-employed role like such, a 1099 typically is not received, leaving it up to child and parent to report these earnings as income to the IRS, and ultimately being required to pay self-employment taxes in order to contribute to their Roth IRAs.
Business Owners Employing Their Kids
If you’re a business owner who puts their kids to work, you can pay your children for the work they do without having to withhold any income or payroll taxes. Please be sure your kids are actually doing work for you. While it is a common practice to feature your children on your website and pay them for modeling or marketing, it is important not to overcompensate them. We would suggest working with your CPA or tax professional to set up a fair process for determining your children's compensation. When work is done, you would issue your employed child a W-2 to report this income and in turn, they can contribute to their Roth IRA.
There is a caveat for businesses structured as an S-Corp or C-Corp. Both business structures can avoid withholding FICA taxes when paying children under the age of 18, when a sole proprietorship ‘management company’ is put in place. While this sounds complicated, it is actually one of the easiest and most legitimate ways to pay your children from your business. Please don’t hesitate to reach out for more information on setting this up!
Bottom Line
Opening and funding a Custodial Roth IRA for your child can substantially increase their retirement savings while also being an educational experience for them as they witness their money grow tax-free.
Brandy Branstetter, CFP®