How to use a Roth IRA as a retirement savings vehicle for a child

Many people think of Roth IRAs as adult retirement savings vehicles. But working children can also save for old age with this tax-privileged savings vehicle.

This year’s Roth IRA contribution limit is $6,000 for those under the age of 50. Those who earn less than the year can contribute their entire earned income. Earned income refers to money earned from a job or self-employment, which includes a paid position in a family business.

There is no minimum age for contributions. For example, if a 14-year-old makes $500 as a camp counselor, or a 16-year-old makes $3,000 as a lifeguard, or a 10-year-old makes $300 as a shelf-stocker for a family-owned bodega, anyone up to that amount can become one of a Parent contributing to child custody opened Roth IRA for the sake of the child. Within a few minutes, a Roth personal account can be opened for the parents with an online broker such as Schwab or Fidelity.

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It’s also a simple transfer process once the child has reached the age of majority, usually 18 or 21, depending on the state.

Still, many people don’t know these types of accounts exist and the multiple benefits they offer, including decades of tax-free growth. “Opportunity cost is one of the biggest costs of all,” said James A. Colavita, board-certified financial planner at GenTrust in New York.

Here are three reasons to open a custody roth on your child’s behalf:

Tax-free investment growth potential

Funds in a Roth IRA are deposited after tax and you can withdraw contributions you have made into a Roth IRA at any time without worrying about taxes or penalties. If you withdraw money before the age of 59 1/2, you will have to pay tax and a penalty on your income, with certain exceptions. These exceptions could provide an added incentive for children who may balk at being asked to put away their hard-earned money for 50 or 60 years.

For example, they could use up to $10,000 on a first home, tax and fee free, as long as the account has been in existence for at least five years. You could also choose to use Roth funds for qualifying educational spending. This avoids the 10% penalty but they still pay income tax on the income share.

Because it is a Roth, the IRS does not require mandatory distributions at age 72 like a traditional IRA. To keep the money growing longer, said Keith T. Barberis, managing director and partner at Barberis Wealth Management in Bethesda, Maryland.

Compound interest benefits for children

“Time is your best friend or your worst enemy when you’re an investor,” Colavita said. “When you start early, time is your best friend.”

Daniel Hawley, a certified financial planner at Hawley Advisors Wealth Planning in Walnut Creek, California, provides the hypothetical example of a child who starts saving at age 10 and pays $500 a year for eight years. Assuming a 9% return on investment, the child at age 67 would have a nominal account value of approximately $478,000. That equates to an inflation-adjusted value of about $142,500 at a constant inflation rate of 2.5%, his numbers show.

If the child had contributed $1,500 annually over the same period, the account would have grown to about $1.4 million by age 67, or about $407,000 adjusted for inflation. “It’s a fabulous wealth-building mechanism. The earlier you start, the less you have to contribute to the backend,” Hawley said.

Also because of the long time to retirement, children should be invested aggressively, Hawley said. “You don’t want to be in a balanced, low-risk fund,” he said.

Teach personal finance early

In recent years, greater efforts have been made to ensure that children receive basic financial education at school. According to the 2022 Next Gen Personal Finance State of Financial Education report, nearly one in four students among states that require high school personal finance education will take a related course before graduating this year.

Even so, many children don’t have a basic understanding of investment concepts or the skills needed to be prudent investors – and they don’t necessarily learn the skills at home.

Still, 93% of teens believe they need financial knowledge and skills to achieve their life goals, and 97% of parents agree, according to a March survey by Greenlight Financial Technology.

This is where something like a Roth IRA can be a wonderful learning opportunity — from both an investment standpoint and a work ethic standpoint, the advisors said. “It teaches them about investing, the benefits of compounding, healthy investing habits, and gives them an incentive to work,” Barberis said.

Another advantage is that parents, grandparents, family or friends can contribute all or part of the amount for the child. This could help a child who is reluctant to part with some or all of their income, and it also offers a financial boost for the future.

“It’s telling the kid, ‘Wow, that’s really important because my parents don’t always like to give me money for everything, but they give me money for it,'” Colavita said.

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