Roth IRA for Kids: A Complete Guide

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We all know that investing for your future is one of the best things you can do for yourself. Helping your kids plan and save for their golden years is even better. 

When it comes to investing, time is the most important factor. So it’s a good idea to start thinking about investing with your kids while they’re still young. And one way to do it is by opening a Roth individual retirement account (IRA).

Let’s take a closer look at how Roth IRAs for kids work and some tips for setting one up.

Setting Up a Roth IRA for Your Child 

It’s surprising how many people ask me about setting up a retirement account for their kids. 

More and more people are getting on board with the idea of working toward financial freedom and the concept that the earlier you start saving and investing in life, the sooner you reach it. 

One way to help your kids on their road to financial freedom is by setting up a Roth IRA, which is an individual retirement account that offers tax-free withdrawals after the age of 59 ½.

It is perfectly legal to set up a custodial Roth IRA for your child at a young age, as long as they have an income. 

When you set up a Roth IRA, the account goes in your child’s name. You act as the manager and maintain control of the account, and it’s your job to oversee operations until the child becomes either 18 or 21, depending on the state where they live. 

This involves depositing money, making investments, and moving money around on the child’s behalf.

Basic requirements for a custodial Roth IRA

To contribute to a Roth IRA during the 2021 tax year, the child needs to make less than $140,000.

There’s also an annual Roth IRA contribution limit to consider. For 2021, the limit is $6,000 or total income earned for the year — whichever is lower. 

To contribute to a Roth IRA, you have to use earned income. In other words, the child has to legitimately make the money through a job or self-employment. This might include tasks like babysitting, mowing lawns, or dog-walking — all of which are examples of taxable income. Unless your child is the Gerber baby, it’s unlikely they are going to have earned income until they approach their teenage years. 

That said, the money doesn’t all have to come from your child. As long as they contribute to the Roth IRA, you or someone else can supplement the account with your own money up to the amount they contribute, and up to the $6,000 limit. 

How to Set Up a Roth IRA for Kids

Opening a custodial account for your child is easy and painless. Follow these steps to get started. 

  1. Have your child research different brokers
  2. Select a brokerage firm
  3. Open an account
  4. Start investing
  5. Keep your child in the loop

1. Have your child research different brokers 

If your kid is old enough, think about asking them to research brokers and explore various options. If nothing else, this is good practice for their own financial future.

Consider sitting down with your child and having them browse through different brokerage websites. This might take some time — and patience — but it presents a valuable learning opportunity. 

Ultimately, you want to convey to the child that this is their account. In the not too distant future, it will be their full responsibility, so it pays to learn how it works and participate in the process. 

2. Select a brokerage firm

Many brokers on the market offer custodial Roth IRAs.

For example, Charles Schwab offers a plan with $0 equity trades, 24/7 professional guidance, and robust online tools and resources.

Fidelity also offers a great custodial Roth account with $0 commissions for stocks, exchange-traded funds (ETFs), and options, as well as no opening costs, no closing costs, and no annual fees. 

3. Open an account 

Once you pick a broker that’s a good fit, go ahead and sign up for the account. Your child won’t be able to open the account on their own; that’s your job as the custodian. 

Go through the registration process and create an account in the child’s name. This is going to require their Social Security number and contact information. 

You will also have to link a bank account once you set up the Roth IRA. This allows you to transfer funds for investing. 

It might take a few business days for the funds to clear once you deposit money into your account. Some brokers, like Fidelity, allow you to make trades before the money is officially settled in the account. 

Just so there aren’t any surprises, check with your broker in advance to see how long the process will take.

4. Start investing 

It can be a little overwhelming trying to decide where to invest your child’s funds. 

Consider the fact that your child’s time horizon will most likely be over seven decades — more than enough time to build a massive fortune through smart and persistent investing.

My advice is to start with low-cost index funds. Putting money into index funds provides immediate market exposure, as well as greater protection from market volatility. Index funds also typically offer solid long-term growth potential.

Focus on building a foundation and then mix in some individual growth stocks. Just keep in mind that adding stocks introduces volatility and requires ongoing maintenance. If you prefer hands-off investing, index funds are the better option.

As you go along, diversify the portfolio by adding different asset classes where it makes sense. For example, you might want to mix in a few real estate investment trusts (REITs). These funds are great because they have to pay at least 90% of their taxable income to investors as dividends.

5. Keep your child in the loop 

Even though you’re the custodian, your child can still participate in the investing process. 

Consider letting your child watch what you’re doing at first and walk them through the steps of selecting and buying investments. Show them how to pick stocks based on factors like dividend yield, market cap, debt-to-equity ratio, and a price-earnings ratio, among other metrics. 

Once the child has a firm grasp on how the process works, let them pick a few stocks on their own. As time passes, their confidence should increase. They may stumble along the way and pick some clunkers, but that can be a great way to learn how to respect the market. 

Follow this approach, and by the time your child reaches legal age, they should have a solid understanding of how the stock market works — and a decent portfolio to boot.

Why Roth IRAs Are Great for Kids

Here are a few reasons why it could make sense to open a Roth IRA in your child’s name.

Build financial awareness 

Many young people today have a basic lack of financial literacy, which is a big problem. For example, one study found that 18 percent of 15-year olds lack fundamental financial skills — like building a simple budget and understanding an invoice.

Opening a Roth IRA and teaching kids about investing is a great way to help them learn how money works. The more you educate your kids about personal finances while they’re young, the better off they’ll be down the line.

Access flexible withdrawals 

Roth IRAs are traditionally meant to cover retirement costs. However, they can also cover certain qualified expenses once the account is at least five years old. 

For example, your child may be able to use the Roth IRA to cover qualified education expenses, put a down payment on their first home, or pay for emergency expenses. 

TIP: Higher education expenses and emergency payments come with a 10% early withdrawal penalty. On the other hand, an early withdrawal for funds going toward the home-buying process is tax-free and penalty-free. 

Generate long-term tax-free growth 

With the right mix of assets, Roth IRAs can increase in value over time through compounding. This is an excellent way to build a nest egg and amass long-term wealth. A child’s Roth IRA could become a tremendous asset over time as more and more money accumulates and grows.

The trick is to try and avoid touching the Roth IRA for as long as you can. While it’s possible to take money out for certain expenses, it’s generally better to avoid doing so. The more money you have in your account, the bigger it can grow.

To make sure your kid has access to cash without dipping into their Roth, consider opening separate taxable custodial brokerage accounts and savings accounts for them.

Traditional IRA vs. Roth IRA for Kids

When setting up a tax-friendly retirement account for your child, you’ll have to decide between a traditional and Roth IRA.

The main difference is a Roth IRA uses after-tax dollars and grows tax-free while a traditional IRA uses pre-tax dollars and grows on a tax-deferred basis. 

The Roth IRA offers a few big advantages for kids. First and foremost, you can potentially set your child up for success later in life by giving them tax-free withdrawals after the age of 59 ½, when they are liable to be in a higher tax bracket. 

Further, your child probably won’t be making enough to pay hefty income taxes until they get a full-time job down the road. So, contribution deductions won’t make a big difference until that time.

Frequently Asked Questions

Below are answers to some of the most frequently asked questions about Roth IRAs for kids.

Do children have to pay a self-employment tax to the IRS?

If the child earns more than $400 during the year, they will need to report self-employment income to the IRS. As such, you should have your child maintain a spreadsheet throughout the year and make sure to put money aside to cover taxes. 

Is a Roth IRA or a traditional IRA better for kids?

It isn’t a matter of one being better than the other. Both are great options for kids because they enable tax-efficient growth over time.

Don’t get too caught up on which one to pick at first because you or your child can easily convert a traditional IRA to a Roth IRA down the line (but can’t do the opposite). 

Does Vanguard offer a Roth IRA for minors?

Vanguard offers a custodial Roth IRA for minors, providing access to low-cost, high-performance index funds and mutual funds.

One interesting thing about Vanguard is that its customers own the company, which is why it can offer funds with impressively low expense ratios. If you’re looking for a brokerage that directly rewards customers, Vanguard is a great option.

Are Roth IRA accounts insured?

All Roth IRAs receive federal insurance protection from the Securities Investor Protection Corporation (SIPC) at a rate of $500,000 in cash and securities per account.

The Bottom Line 

Opening a Roth IRA for your child is a clever way to give them a head start in their financial journey. 

A Roth IRA offers excellent tax advantages and it can also teach financial discipline by getting kids in the habit of putting away money for long-term growth.

Spend some time researching various options with your child and select a broker that matches your needs. After that, dive in and start investing. 

At the end of the day, getting your kids on board with investing is one of the smartest things you will ever do. You’ll be giving them the gift of financial freedom — long before they truly understand how important that is. 

How cool is that?

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