One of the best ways to give your child a head start on their financial life is to set up a Roth individual retirement account.
While a Roth IRA isnt for everyone, you might be surprised at how beneficial it can be – and how easy it is to set up.
If you want to help your child start saving money now, a Roth IRA can be a good way to go about it. Heres what you need to know:
- What is a kids Roth IRA?
- How much can your child contribute to a Roth IRA?
- Benefits of a kids Roth IRA.
- How to open a Roth IRA for your child.
What Is a Kids Roth IRA?
Basically, a childs Roth IRA is one that you act as custodian for. Because your child is a minor, they cant open their own account. However, as long as your kid meets eligibility requirements, you can open one on their behalf and even make contributions.
Once your child reaches the age of majority, they can take over management of the account. And, like any Roth IRA, the money will grow tax-free. Your child can withdraw the money penalty-free once they reach age 59½.
Additionally, its possible to withdraw contributions – not earnings – at any time without paying a penalty.
How Much Can Your Child Contribute to a Roth IRA?
One of the requirements for opening an IRA on behalf of your child is that they need to have earned income. So, before you move forward, you need to make sure your child is making money. This can be done through a job, or through income gained through activities like babysitting, yardwork or pet sitting.
The contribution limit is $6,000 for 2020, or 100% of earned income, whichever is less. So, if your child only makes $2,000 in a year, then they can only put $2,000 into the Roth IRA. However, even that amount can be very valuable when accounting for compounding returns over time.
Benefits of a Kids Roth IRA
One of the biggest benefits of opening a Roth IRA for your kid is that they have the potential to reap the benefits of tax-free growth.
Its very likely that your child wont owe any federal income taxes due to their relatively low income. As a result, even though contributions to a Roth IRA are made with after-tax money, that wont matter to your kids – who dont pay taxes.
Starting early, with a low income, offers a way for your child to take advantage of tax-efficient compounding returns over a longer period of time.
However, there are other benefits, especially if you open a custodial IRA for your child earlier on. For example, if the IRA has been funded for at least five years, its possible to take out $10,000 – including from earnings – to buy a first home. This can help your child make a down payment on a home later on.
On top of that, Roth IRA earnings can be removed for qualified education expenses without paying a penalty. Your child still has to pay taxes on the earnings that are distributed for this purpose, but they wont be subject to the 10% early withdrawal penalty.
These are potentially good ways to help set your child up for a better financial future with a strong foundation, just because you encourage them to set aside money in a Roth IRA.
How to Open a Roth IRA for Your Child
First, you need to find a broker that offers custodial IRAs. Not all brokers offer them, and many robo advisors dont offer custodial accounts. However, there are a number of options that do offer these types of accounts. You need information about your childs identity, including Social Security number, as well as to provide your own information.
Basically, anything you need to open an account for yourself youll need to provide as the custodian of the account.
Thats pretty much it. Once you have your account open, you can begin to make payments.
Its even possible to open a Roth IRA on behalf of your infant – as long as you can show the child is making earned income.
For example, Sandy Smith, founder of Yes, I Am Cheap, uses her son as a model as part of her entrepreneurial ventures. She has to pay him, though, and make sure theres documentation of the payments and the fact that the money goes into an account for his benefit.
When hiring your children as part of a business, you need to make sure they are doing actual jobs and receive pay that can be tracked with a paper trail.
As long as youre following the rules and are careful to ensure that your child has earned income, you should be able to open a custodial Roth IRA and start your kids on the path to financial freedom.
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