Roth IRA Rules For Minors. Your Kids Guide to Tax Free Money

Joseph Meyer
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Roth IRA For Minors

Whose the Owner?

While we hear a lot about IRAs, there seems to be a lot more confusion about Roth IRAs. One important question — who actually owns the Roth IRA? Some believe that as long as the money is invested in the Roth IRA, it belongs to the account owner. But since the early 2000s, when the Roth IRA rules changed, the answer is not as simple as that.

In 2005, Congress passed the Pension Protection Act. This was the point at which the Roth IRA rules changed. In order to take advantage of the non-taxation of Roth IRA distributions, the legislation imposed the following criteria:

  • You must be allowed to take Roth IRA distributions at any time
  • You must have had a Roth IRA for at least five years

You must be at least 59.5 years of age

It has been made abundantly clear by the IRS that in order to take advantage of the tax-free status of a Roth IRA, the Roth IRA must be owned by the account owner, and not by a minor.

Drawbacks of Roth IRA’s for Kids

There is no minimum age requirement to open a Roth IRA for kids. As long as the account holder is under the age of 70 and has earned income, he/she is qualified to open a Roth IRA.

Like other IRA’s, funds contributed to a Roth IRA grow tax-free, so long as the funds are kept invested for at least five years. Free of taxes, earnings in the account will shield your child from some of the uncertainties associated with investing.

When your child is ready to withdraw, they will have the option to pay taxes at their then current tax rate or withdraw the money without penalty.

Accordingly, a Roth IRA for underage kids can be a great way to help them save for big ticket items they may need in the future – like a college education. However, there are some drawbacks of Roth IRA’s for kids that parents should consider before opening an IRA.

Can You Just Open a Roth IRA for the Child?

Even when they are young, kids should get the concept of saving for retirement as soon as possible. They don’t have much money in the first place, but they can put away what they have in a Roth IRA, which will allow the money to grow over time and be withdrawn in retirement tax free.

Due to the minor’s age, an adult will need to establish a Roth IRA for them. In fact, it’s best to start getting your child used to the idea of saving money early on.

Be sure to choose a direct Roth IRA that is not available on custodian accounts. Doing so will allow your child to maintain ownership of the account, not just on paper but actually throughout the entire investment process. A custodian account requires that the custodian withdraws contributions received on behalf of an account holder (in this case your child) and transfers them to the investment. In a custodian Roth IRA account, the custodian has control over the contributions until they are invested under the name of the minor.

The preferred option is, of course, to open a Roth IRA where the child is the sole owner. That way they have total control over the account, and they can watch the money grow from a young age.

Different Strategy

As soon as a minor reaches the age of 18 they are considered an adult for all purposes including financial status, just the same as you and I. That means that you want to decide on your investment style immediately after your child turns 18, and in some cases before that, to ensure that your birthdays aren’t all celebrated twice.

Even though your child is now an adult, there are certain things that you can do as a parent to make the process a little easier, including an IRA.

What is an IRA? It is an Individual Retirement Account, something that retirement age baby boomers are familiar with and have been using for years to reduce their tax burden. An IRA is a special retirement account which is a type of tax-advantaged savings plan, where you can save money for your retirement age.

There are several different types of IRAs, such as Roth IRAs, which we will focus on. Under certain circumstances some kids can open and use a Roth IRA. These circumstances include being a student and having no earned income. There are rules that you have to follow and that you need to understand, which are relatively simple, but if they are overlooked the IRS will come after the money.

Another possibility

Along with a custodial account, explore a Roth IRA that your child can enjoy after he or she reaches age 18 or 21, depending on the rules of the IRA owner.

As the name suggests, you contribute after-tax dollars to a Roth IRA and the money grows tax-free. Some types of investments are not allowed in a Roth account. Information about which investments are allowed for a Roth IRA can be found at TD Ameritrade in the section titled “What can be purchased in a Roth IRA.” However, as your children’s situation may differ from those in the examples provided, you’ll want to contact your tax advisor to determine what investments might make sense in their Roth IRA.

Contributions can only be made to a Roth IRA if your child has earned income. Keep in mind that while your child may work and earn money, that money may be exempt from federal tax and may not be taxable at the state level. The good news is that earned income, which is defined as a money payment made for work, includes a number of different items that will make Roth IRA investing much easier to attain. Some examples include:

Money earned from work (including babysitting, lawn mowing, etc.)

Where to Open an Account

If you have a child that’s between the ages of 14 and 18, chances are that he or she is interested in investing. Chances are, you have tried to discourage this. After all, you know firsthand how risky investments can be. But, you’ve come to the conclusion that your child would only listen to a professional.

So how do you help your child open an account with a proven track record of success?

If you are wondering how you can open an IRA account for a minor, there are two options to you. One option is to open an IRA account with a stock broker on behalf of your child. The other option is to open a custodial IRA account and let your child be the account owner.

Which option should you choose? If the sole purpose of opening the account for your child is for tax benefits, the custodial IRA is the only option. This allows your child to receive 100% tax benefits since, as the custodian, you will be responsible for paying taxes for the income he or she generates.