A common question we get from the parents and grandparents of younger children is, “What’s the best way to save for a child’s future?” Most people are typically thinking about one of two options when they ask this question. They’re trying to decide whether to open a custodial brokerage account or start a Section 529 college savings plan.
Each option has pros and cons, with the custodial account offering unfettered access to the funds upon the child reaching the age of majority, while the 529 limits the use of the funds to education-related expenses in order to avoid penalties, as well as varying tax treatment. But depending on the circumstances, a third option may appeal: starting a Roth IRA for a child.
Coupled with the ability to use Roth funds to pay qualified education expenses without incurring early withdrawal penalties (although earnings withdrawn prior to age 59 ½ would be taxed as income to the child), starting a Roth for a child can be a more flexible way to take advantage of the miracle of compounding in the early years before it’s set in stone that the child will need funds to pay for college, while also ensuring they don’t make ill-advised choices with money in a custodial account before they perhaps know any better as a young adult.
The most important factor that will determine whether a Roth IRA is the way to go for a child will be whether they can establish that they have earned income. But first, let’s cover a few of the basics in starting a Roth IRA for a child.
How old do you have to be to have a Roth IRA?
You may be surprised to learn that Roth IRAs do not have an age limit, meaning an account can be established for a newborn as long as they have a Social Security number and earned income (discussed further below). However, until the child reaches the age of majority (18 in most states, 21 for the rest), the account needs to be set up as a custodial account.
This can be done by any adult, including parents, grandparents, godparents or even just generous friends, with the child being named as the beneficiary of the account. Upon reaching age 18 or 21, the child then becomes the account owner and would need to name a different beneficiary.
What information do I need to start a child’s Roth IRA?
To open a custodial Roth IRA, you’ll need the minor’s full legal name, Social Security or Tax ID number, date of birth and address. The account owner/custodian will also need to supply their own personal information to open the account.
How do you establish earned income for a child’s Roth IRA?
While there are no age requirements to open a Roth IRA for a child, there does need to be earned income to support any contributions, regardless of the source of the contribution. Meaning, for example, if a parent wants to “match” a child’s baby-sitting wages by putting an equal amount into the Roth IRA on behalf of the child, the total amount put into any IRA in the child’s name may not exceed the child’s earned income in the year of the contribution, up to the annual limit for account holders under age 50 ($7,000 for 2024).
It's also worth noting that such “matching” contributions would count as a gift against the contributor’s annual exclusion amount.
Earned income can have a broader definition than just W-2 based income, which is where a lot of the confusion ensues when discussing the possibility of opening a Roth IRA for a younger child who isn’t yet old enough to work. However, it’s typically simpler to establish, which is why this strategy is more commonly known and used by family-owned businesses who often employ children in order to make such contributions.
Outside of W-2 wages, other paying work can count, as long as it is properly recorded and taxed: baby-sitting, leaf raking, being a parent's helper, etc. are all valid sources of earned income. Even newborns who can’t yet contribute much beyond sleep deprivation may be able to earn, typically via modeling or acting gigs, such as using the child in an Instagram video for a parent’s business.
Beware of overly inflating wages for this type of work, however. It is feasible that a child may be paid $6,000 to spend a day on set shooting marketing photos, but $2,500 for a day of making copies could raise eyebrows should the IRS seek details on the income earned.
Money paid for chores generally doesn’t count, so it’s best to use paid work either outside the house or for tasks that go above and beyond the day-to-day contributions of running a household.
How do you document the income and what about taxes?
In order to avoid questions from the IRS, it’s best to keep a record of earnings that aren’t reported on a W-2 or 1099. A spreadsheet will suffice, and it should include similar information one would find on a timesheet, then it’s also a good idea to file a tax return regardless of the filing requirement when contributing to a Roth IRA. Self-employment income and taxes will come into play if the money earned is more than $400 and not reported on a W-2.
Above all, opening and funding a Roth IRA for children can be an excellent way to start children on a journey toward a lifetime of financial well-being by pairing opportunities to teach the value of hard work with the unmatched benefit of the time value of money invested early in life. Just be sure to properly document earned income to support any contributions made.
And of course, let us know how we can help with establishing such an account as part of your family’s Prosperity Plan. If you’re not a client of the Prosperity People, we’d love to talk with you. Reach out today to schedule a chat so we can start you and your family on the path to prosperity.