November 22, 2022

Is A Custodial Roth IRA A Good Idea for Your Child?

Is A Custodial Roth IRA A Good Idea for Your Child? ABSOLUTELY! Here's why:

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Is A Custodial Roth IRA A Good Idea for Your Child?

The answer is yes, it is. One of the best things you can do for your child's future is to open a Roth IRA for them as soon as possible!

A Roth IRA is the best way to save money for the future and let it grow over time. The catch is that it only works if you have money coming in from a job. For you or your child to be able to put money into an IRA, you must both have your own source of income, otherwise known as earned income. Meaning, you can't just give money on their behalf IF they don't make money

How to get around this? Well, if you run your own business, you can hire your child to do tasks that are appropriate for his or her age and pay him or her a fair wage. This is an easy way to make money on paper so you can fund your Roth IRA!

Bonus: Match the amount that he/she puts into their Roth IRA. This will help turbocharge their savings.

Read more: 5 Tax Saving Strategies for Business Owners

IRAs are great ways to save money for young people because of the time that they have! Because children are young and have many years ahead of them, they can take full advantage of time and the power of compounding in this type of tax-advantaged savings vehicle. 

Let’s take a look at some IRA’s available to kids.

Types of IRA’s For Kids

There are two kinds of IRAs that are good for kids, traditional and Roth. The main difference between traditional and Roth IRAs is when you pay taxes on the money you put into the plan. 

Traditional IRA 

When you take money out of a traditional IRA, you have to pay taxes on it (at your then-applicable tax rate). In a traditional IRA, all of the money, including your contributions and any earnings, is considered pre-tax.

Roth IRA 

When you put money into a Roth IRA, you pay taxes on it. This means that both the money you put in and the money it earns are considered "after-tax" money. In either a traditional or a Roth IRA, the money grows without paying taxes on it. 

But the benefit of a Roth is that the child would not have to pay income tax on the money when they withdraw it many decades later. Also, the money does not have any required minimum distributions (RMDs).

Read more: Roth IRA: A Basic Guide

Why Roth IRAs Are Good for Kids

Children can put money into a Roth IRA and let it grow tax-free for decades. The value of an account grows by a factor of ten because of the power of compounding. First, all profits will be added back to the principal, and then they will be re-invested in the stock market to speed up the growth of the account.

As Benjamin Franklin said, "“Money makes money. And the money that money makes, makes money.” 

Opening a Roth IRA for Your Child

There are a few banks that offer these kinds of accounts, like Fidelity and Charles Schwab. Spend some time learning about what they have to offer so you can choose the best Roth IRA for your needs.

After you choose a company, opening your account online takes only a few minutes. You'll need to give some basic information about yourself and your child, like your Social Security number, where you work, how much money you make each year, and how much money you have in the bank.

Once your account is set up, talk to your child about how much and how often they'll put money in. You can put in the same amount as your child as long as the total doesn't go over how much money they made that year.

Ready to open a Roth IRA? The advisors at Vincere Wealth can help! Speak with a Roth IRA expert here.

How to Put Money in a Kid's IRA

As long as they have income from a job, such as a lifeguard position, etc., children of any age are eligible to contribute to IRAs. The maximum your child may contribute to a regular or Roth IRA in 2023 is $6,500 or their annual taxable income. The cap was $6,000 in 2022. Your youngest child, for example, might contribute up to $3,000 to an IRA if they earn $3,000 this year.

Note: The important thing to remember is that your child must have earned income during the year for which a contribution is made. Money from an allowance or investments does not count as earned income, so it cannot be used to make contributions.

Your child should get a W-2 or 1099 for work done, if possible. But of course, that does not usually happen with businesses like babysitting, yard work, dog walking, and other common jobs for young people. So, it is smart to keep records and the receipts. The following should be among these:

  • The type of job
  • When the job was finished
  • Who the job was done for
  • How much money your kid got

Note: The money cannot come from an allowance (even if the child does chores for it) or a cash gift given directly to the child. Still, you cannot give your child an allowance, but you might be able to pay them for work they do around the house, as long as it is legal and they get paid the going market rate. (you cannot pay $1,000 to have someone watch your kids for the night.)

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Money related to a divorce, like alimony, child support, or a settlement, can also be given if it is taxable alimony from a divorce settlement signed before December 31, 2018. You do not get a tax break for the contribution. However, depending on your income and other factors, you may be able to take a Saver's Tax Credit of 10%, 20%, or 50% of the deposit.

Vincere Tax can help you save big on your tax bill. Stop leaking money to the IRS. Start saving today. Speak with an advisor today.

Can someone else put money in a child's Roth IRA?

Yes. You or someone else can give money directly to a child's Roth IRA. They really are gifts that keep on giving! Since Roth IRAs can be used to buy almost any asset, they tend to do much better than savings bonds or bank accounts. Many parents choose to add the same amount to their child's IRA as the child earns. If your child gets a summer job and makes $3,000, you can let them spend it however they want and put the $3,000 in your own IRA. You could also offer to give a certain amount, like 50%, of what your child earns. (Your child makes $3,000 a year, and you give them $1,500.)

Note: Do not forget to think about gift tax rules. The money you put into a Roth IRA for your child will count toward the $16,000 (rising to $17,000 in 2023) limit on tax-free gifts you can give to one person. No matter what you do, the IRS does not care who gives the money as long as it does not go over your child's earnings for the year.

For example: If Jack made $2,000 one summer, you or Jack can only put $2,000 into the IRA. Since the money goes into your child's IRA, the tax break goes to your child, not you.

What Kids Can Get Out of IRAs

IRAs are a good way for kids to save money and build a nest egg, but they also have other benefits, both now and in the future.

  • Financial Literacy: When you open an IRA for your child, you not only give them a head start on saving for retirement, but you also teach them important lessons about money. Even a small IRA can be a good way to teach your child about investing and the relationship between making money, saving money, and spending money. It can also teach them about compounding, which works best when it has the most time to do so.
  • Accessible Money: Another benefit of IRAs is that your child may be able to use them for other important costs, especially if they are Roth's, which let you take out contributions after the account has been open for at least five years. Regular IRAs have more rules, but there are times when you can take money out without paying a penalty.
  • Education costs: The account holder can take money out of the account to pay for college, but they will have to pay taxes on the money. But if the money is used for qualified education costs, there is no 10% penalty for taking it out early (tuition, fees, books, supplies, equipment, and most room and board charges).
  • Buying a house: The owner of the account can take out money to buy a house before he or she turns 59 1/2. The money must be used as a down payment or to pay for costs related to closing. The most you can take out is $10,000. When you take money out early to buy a home, you do not have to pay taxes or a penalty.
  • For emergencies: In an emergency, the owner of a Roth IRA can take money out of it. But you will have to pay taxes on the earnings and a 10% fee for taking the money out early. If you can avoid it, it's best to keep these funds together and not use them to buy your first home.

Can I Set Up an IRA for My Child?

Yes. No matter how old your child is, they can put money into an IRA as long as they have earned income. The IRS defines earned income as all the taxable income and wages you get from working for someone else or running your own business.

Are you ready to start today? The team at Vincere Wealth can help you get started. Speak with an advisor here.

How Much Money Can I Put in an IRA for My Child?

A child's IRA contributions cannot be more than what he or she makes. For instance, if a child earns $1,000 in a year, they can only put $1,000 into the account. In 2023, the most a family can contribute is $6,500 per child per year, up from $6,000 in 2022.

How Does an IRA with a Custodian Work?

A custodial IRA is an individual retirement account that is held by a custodian, who is usually a parent, for a minor who works and earns money. Once the custodial IRA is set up, the custodian takes care of all the money until the child turns 18. (or 21 in some states).

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Wrapping Up

When it comes to investing, young people have a huge advantage: TIME. Because they are still young, compounding goes into high gear because they have a long way to go.

Most of the time, Roth IRAs will be in a low or even no tax bracket. Even small amounts put into an IRA can grow into a lot over time. In addition to the cash that will grow in an IRA account, your child will also learn how to handle money well: The sooner kids start learning about money, the more likely they are to be financially stable as adults! It might be hard to convince kids to open an IRA when they could spend the money they have earned or save it for college, which will happen much sooner than retirement. However, opening an IRA early can mean a lot of financial security in the future.

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