Roth IRAs can be established and owned by anyone who has earned income and that includes children. As many savvy investors have come to understand, Roth IRAs offer the best tax-free treatment for investment income and returns in the tax code. But these accounts aren’t just for adults. Minors who have earned income can also establish Roth IRAs.
I have many clients who establish Roth IRAs for their children who have earned income. Some use them to co-invest those funds with their own Roth IRAs into certain real estate deals or start-up companies. Some open up brokerage accounts and teach their kids how to buy and sell stocks. Whatever your investment strategy, don’t leave your kids out. Consider a Roth IRA as a valuable tool that can be used to teach your kids or grand-kids how to invest and how to save for their own college education. But before you open up a Roth IRA for your child, here’s what you need to know.
- Earned Income – The only qualification to establishing a Roth IRA is that the account-owner has earned income. If your child works in your business, on your rental properties or real estate investments, or even if they have a part-time or summer job, give them some income so they can establish a Roth IRA. Their earned income can be contributed to the annual Roth IRA contribution limit of $5,500. My own 13 and 15 year-olds actually have their own small business and we will be establishing Roth IRAs this year for both of them. If a child has made a Roth IRA contribution, it is generally recommended that they either have a W-2 for the income for that year or that they file a 1040-EZ for their 1099 income or self-employment income even if they are under the standard deduction. While earned income to a child is taxable, if the child is under the standard deduction amount of $6,200 the child will pay no income tax (though there may be employment taxes).
- Custodial IRA – If you open a Roth IRA for your child it is often times referred to as a custodial IRA because the account owner is not old enough to establish the IRA for themselves and therefore their parent or legal guardian must open and oversee the account for the child. When the child reaches age 18, the child will take over as the responsible party for the account.
- Tax & Penalty Free With-Drawls – In all instances, the amounts contributed to a Roth IRA can be withdrawn penalty free and tax free. Earnings withdrawn may be subject to a penalty and tax. Earnings may be distributed penalty free for the qualified higher education expenses of the child though the earnings withdrawn can be subject to tax. Check out the IRS explanation here. http://www.irs.gov/publications/p970/ch09.html. In other words, the Roth IRA can be accessed without penalty or tax when you simply pull out the amounts comprising contributions to the Roth IRA. Keep in mind, the withdrawn earnings used for qualifying higher education expenses (e.g. the investment returns or growth in the account above the contributions) will not be subject to the 10% early withdrawal penalty but they may be subject to taxes on the child’s tax return. As a result, I wouldn’t recommend withdrawing the earnings. While using a child’s Roth IRA for education expenses is common, it is not just education expenses to consider as contributions to a Roth IRA can be withdrawal without penalty and tax for anything. That could be a new car purchase, a non-traditional education expense, church service expenses, a new business, job training, or any other worthy cause or purchase worth saving for.
If you want to teach your child how to invest or if you want to help them save for college, the first account option to consider is a Roth IRA. Why choose an account that is taxable when you can choose one that grows tax-free?