How Does a Custodial Roth IRA Work?

Teaching your children how to save money can often be a difficult job. One avenue you can take is to open a custodial Roth IRA for them. Minor children cannot usually open a brokerage account on their own, but you can establish a custodial Roth IRA for them with the goal of saving for college, retirement or other possible expenses. Grandparents, parents and others can help the child with contributions. If you’re not sure how this fits into your financial plan, consider working with a financial advisor who can answer all your questions and help set your kids up for financial success.

What Is a Custodial Roth IRA?

A custodial Roth IRA is a Roth IRA for kids that can help them with their future finances. It works exactly like a regular Roth IRA with a few exceptions. The standard Roth IRA is funded with after-tax dollars. This means that when you make withdrawals from it during retirement, they are tax-free.

Another benefit is that since the standard Roth IRA is funded with after-tax dollars, it can grow tax-free during the years up to retirement. When you fund a standard Roth IRA with securities, they will earn capital gains and dividends which are entirely tax-free after retirement.

A custodial Roth IRA works much the same way except the parent has to open the account. The parent is then designated as the custodian of the account and the minor child is designated as the beneficiary. When the child reaches the age of adulthood in your state, usually 18 or 21 years of age, the custodial Roth IRA is transferred in full to them.

They don’t have to wait until retirement age to draw out the money since the purpose of the custodial Roth IRA is for college or other major expenditures. By this time, one hopes, the child has learned how to manage money.

Custodial Roth IRA Contribution and Income Limits

There is one other important feature of the custodial Roth IRA. The contribution limit for both the standard Roth IRA and the custodial Roth IRA is $7,000 in 2024 (up from $6,500 in 2023). But, for the custodial Roth IRA, contributions can be made only up to the level of earned income by the minor child. If the child mows lawns, runs errands or babysits, contributions can be made only up to their earned income for for the current tax year. The child can make those contributions out of their earned income or a parent or grandparent can contribute that amount.

It’s possible that there may be Social Security or Medicare concerns. It’s best to consult with a tax professional to see how to handle the tax implications of a custodial Roth IRA. In order for the custodian to be knowledgeable, it’s best to keep a log of earned income especially if it is self-employment income.

The income limits for 2024 for a custodial Roth IRA are the same as for the standard IRA. However, they are seldom relevant for the Roth IRA for kids. The eligibility for both the standard Roth IRA and the custodial Roth IRA starts to fade out at $146,000 ($138,000 in 2023). After you earn an income of $146,000, the eligibility starts to phase out and is gone completely at $161,000 ($153,000 in 2023). If you’re married and filing jointly, these thresholds are $230,000 and $240,000 ($218,000 and $228,000 in 2023), respectively.

Pros and Cons of Opening a Custodial IRA

A custodial IRA might be a great way to get your kids started in the right financial situation for their future. However, there are some drawbacks that you should be aware of and compare each to the benefits before making the right decision for you and your kids. Here are the biggest pros and cons to custodial IRAs.

Pros of a Custodial IRA

Custodial Roth IRAs usually earn more than a traditional child’s savings account.
The Roth IRA is a good choice for someone in a lower tax bracket, which usually applies to a child. A child’s earnings may be so low that they are not taxable. A traditional IRA would not be a good investment in this case since there is no possibility of any tax advantages.
There are no early withdrawal penalties on contributions to a custodial Roth IRA. Most retirement accounts charge a 10% penalty if you make a withdrawal before you are 59.5. Your child can withdraw money for college, for starting a business or any other kind of expense.
Your child can take advantage of the power of compounding much earlier than usual. Even a modest nest egg started at a young age will turn into quite a handsome sum of money by the time retirement rolls around.
Your child can withdraw up to $10,000 worth of earnings from the IRA, without a penalty, for the purchase of a home.

Cons of a Custodial IRA

There are contribution limitations in place. There are other options for retirement plans that have higher contribution limits.
Even though you are not assessed a penalty on the contributions when you withdraw them, you may be assessed a penalty on the earnings like interest and dividends.
Custodial Roth IRAs are not tax-deductible.

How to Open a Custodial Roth IRA

All you have to do is go to your bank, broker or investment management company and ask to open an account. They will take care of it after you provide them with some identifying information. You are established as the custodian and your child the beneficiary. You can learn more from our free guide to opening a custodial Roth IRA.

Bottom Line

A custodial Roth IRA is one good approach to saving money for the future needs of your child. If the child decides to save it for retirement, they can have quite a nest egg at age 59.5. If the child has more immediate needs like college or some other large purchase, they can withdraw the contributions early with no penalty. Perhaps this type of account can be one in your arsenal for providing for the future needs of your child.

Tips on Investing

If you need help deciding how to fund your custodial Roth IRA or figuring out your tax situation, it would be wise to contact a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals get started now.
If you want to see how much your investments with a guaranteed return will grow over time, check out SmartAsset’s investment calculator.