Getting Your Kids Started with Custodial Roth IRAs
While most people think of Roth IRAs as a way to save money for retirement, it is actually a great way to save money . And the best part is that the the money can be withdrawn without penalty under certain circumstances. For this reason, Roth IRAs are great for very young investors as long as they have earned income.
Roth IRAs
Investment Amount: $500
Riskiness Level = Depends on Investment Choices
The Roth IRA was established by law in 1997 in order to encourage people to save money for their retirement. However, socking money away for the “big payoff” at retirement five decades down the road is not going to motivate your kids to invest in a Roth IRA.
Your young investors will need a little incentive from you to get going with an IRA, even though you may think the only incentive they need is that it’s for their own good.
Fortunately, the Roth IRA has also become a way for people to save money while benefitting from some tax relief even if they withdraw money before retirement. There is really no minimum investment amount to establish a Roth IRA account but some online brokers may have their own minimums. For this reason, we suggest that $500 should be enough to get your kids started.
How Roth IRAs Work
The Roth IRA is not actually an investment. You can think of it more like an investment pool you establish in which you can deposit stocks, bonds, and other assets.
Adults and minors (which are young people less than 18 in most states) can establish Roth IRAs if they have what’s called ‘earned income’, which is generally considered money one makes through a job.
Kids can invest in Roth IRAs through custodial accounts normally established by a parent or guardian.
Once a Roth IRA is established, either through an online broker or a bank, your child can make annual contributions with after-tax dollars which are then used to make the actual investments contained within it. How much your child can contribute annually, however, is based on his earned income, subject to a maximum level set by the Internal Revenue Service (IRS).
The contribution to your child’s Roth IRA can also come from from you, his grandparents, and other relatives as long as you collectively contribute no more than his earned income.
However, the current maximum annual contribution level (no matter who makes the contribution) is about $6,000 so it is unlikely that your child will breach this limit unless he makes a lot of money on a job.
Contributions Can Be Withdrawn Anytime
Original contributions to a Roth IRA, as opposed to accumulated earnings (the profits generated by the account), can be withdrawn tax-free prior to age 59½ without a penalty, after five years.
If, however, your child withdraws all the contributions, then proceeds to withdraw the accumulated earnings in the portfolio before turning 59½, he will pay taxes on the earnings and also pay a 10% penalty on such earnings. There are limited exceptions to this rule, including withdrawals for paying qualified education expenses, which is great for young people who intend to go to college.
Ultimate Benefit of a Roth IRA
The advantage of a Roth IRA is that if your child makes money on his investments (such as interest, stock gains, etc.), those earnings are not taxed subject to meeting the conditions established by the IRS.
This is an important benefit because ordinarily, you will have to pay taxes on investment gains. For example, if your child invested in the bond of a corporation outside of the Roth IRA framework, he would have to pay taxes on the interest he earns on that bond after meeting a minimum threshold for tax payments.
The Roth IRA eliminates this tax, subject to IRS rules, with the tradeoff being that the account owner is discouraged from touching the account’s investment earnings until he is 59 ½ years old.
Where to Set Up a Roth IRA
A Roth IRA, can be set up through a bank or online broker. Many brokers will open custodial IRAs for minors. However, fees and minimum balances can vary, so you should shop around.
To qualify as a Roth IRA, the account must be specifically designated as such. Contributions to the account must be made in the form of money (cash, check or money order), and that money can then be used to buy stocks, bonds, ETFs, mutual funds, and other assets for the account.