As parents it is important to be good role models for our children. Dave Ramsey Personality Rachel Cruze states “More is caught than taught”. This statement is especially true when it comes to how we, as adults, handle our finances. An integral part of a child’s development is teaching them a good work ethic and financial habits. Educating our children from an early age on how to give, save, and spend responsibly and intentionally will help to set up them up for financial success. As parents, we can provide inspiration as to how they can make a small income. This will then open the opportunity to discuss and help our children understand different investment opportunities available to them, such as a Custodial Roth IRA.
Custodial Roth IRA
This is an Individualized Retirement Account established for a minor, where the contributions are made with the income after tax dollars.
How to Open a Custodial Roth IRA Account
Since the child is a minor, both the legal guardian and the minor need to sign the contract for the Custodial Roth IRA. To open this account, certain information is needed from both the parent opening the account and the child such as Social Security numbers, employment detail, annual income, and banking information.
Contributions
The contribution limit for a Custodial Roth IRA is the same as a regular Roth IRA which is $6,000 a year or cannot exceed the minor’s annual income. The custodian of the account is allowed to match the child’s contributions dollar for dollar, as long as it does not exceed the child’s annual taxable income. Example: If your child makes $5,000 a year and wants to contribute $2,500, you as the parent or legal guardian can also contribute $2,500.
Eligibility
To be eligible for a custodial Rolth IRA, your child needs to have an earned income. The definition of earned income is broad so your child could be working in a W-2, paycheck type of situation or they could just be babysitting. The key here is your child must be earning an income and paying taxes on it. This can create additional costs such as Medicare and Social Security taxes, so we recommend you consult with a tax professional such as our local Ramsey Solutions Tax Endorsed Local Provider, on staff.
Taxes
When the child reaches legal age, the Custodial Roth IRA will convert to a “Normal” Roth IRA and the account will be transferred into the child’s name. There are no taxes that are incurred during the transition from the Custodial Roth IRA to the “normal” Roth IRA. As a Roth IRA, there are no taxes on the growth or on the distributions after 59 ½. However, taxes and penalties incur if there are unqualified withdraws taken from the Roth IRA prior to the age of 59 ½.
To help your child understand the importance of consistent contributions, try using a basic investing calculator such as the one offered by Dave Ramsey: Ramsey Solutions Investment Calculator
At 15-years-old, if your child was to start a Custodial Roth IRA with a one-time contribution of $1,000, by the time he or she was 65 years old it would grow to $144,000 based on average growth of 10% (Stock market average since 1992), based on Prudential’s Asset Allocation Chart which can be seen here.
If this same 15-year-old child contributed $1,000 every year until he or she was 65 years old, (Principal total of $50,000), the total account will grow to $1,443,639!
Really neat scenario; this same 15-year-old child contributes $3,000 a year and the parent or legal guardian matched that contribution until he or she is 18 years old, then the child contributes $6,000 annually until 65 years old, (Principal total of $300,000) the account would grow to 8,362,195!
Remember Ben & Arthur, from Financial Peace University. This is an excellent way to change your family tree, as one goal of Financial Peace University articulates.