Why and How to Start a Roth IRA for your Child

Roth IRAs are super powerful. You put after-tax dollars into it, and you take the money out tax-free in retirement when you are over age 59 ½. They can create a ton of flexibility in retirement to manage your tax bill each year when you're facing taxable income from your traditional IRAs, pensions, 401ks, etc. If you think taxes are going up in the future, they can help you because you are putting in money today that you already paid tax on at a lower rate than in the future. So, if you are below the income limits of 140k single and 208k married filing jointly, then contributing the 6k max contribution every year is pretty much a no-brainer. 

Now, if you have kids, I want you to consider opening a Roth IRA for them. And let me tell you why. You can also hear it on our investing podcast called Invest Smarter.

Education

A big reason to open a Roth IRA for your child is that it gets them involved in investing early. It’s a great moment to teach your child about investing. I am particularly fond of this idea because I love investing and believe in having a  portion of my investments be in individual stocks that I am passionate about. Get your child thinking about all the things he loves in his own life. Maybe it's sports, and perhaps it's video games, maybe it’s clothes, fashion, art, science, you name it. Whatever it is, talk to them about investing in some of the companies that your kid interacts with on a day-to-day basis and already has a lot of belief in and love for. Of course, this is an excellent moment to teach your child that just because you like something doesn't make it a good investment. Download a free app like Webull, and check out easily digestible financial trends, the analyst ratings, the balance sheet. Get them starting to think like an investor.

I think the earlier they get engaged with investing, the better. There are a lot of valuable lessons that can be taught during this process. And it's no secret that personal finance is woefully missing from school curriculums. However, that is starting to change, with 25 states introducing personal finance bills this year. Regardless, a lot of the education on saving, investing, and managing your money sensibly is going to fall on the shoulders of parents. Studies have also shown that, predictably, kids that are educated earlier on personal finance are more likely to acquire lower-cost college funding. 

Compounding is better than saving

The next big reason to open a Roth IRA for your child is that they are young, which means more time and more opportunity to compound. This is probably the most practical reason to do it. And the easiest way to make this point is through examples. If your child is more interested in spending their earned money on trips with friends, a new car, or something that isn’t particularly needed, then pulling up a compound interest calculator is a fantastic way to illustrate the power of compounding. Show them that, by maxing out the Roth IRA two years in a row with their summer earnings, then in fifty years at 7% annualized average return, he would have almost 400k. If they say, “oh well, mom and dad, I don't want to wait 50 years,” then show them what it will look like if they max it out every year. Now that it's over three million dollars in fifty years, they may feel a little more excited. But it's still 50 years away, so show them how in 10 years it'll be over 100k, and in 20 over 300k. And if your child is 16, you can be like, you'll be 26 and have already saved over 100k. When you're just 36, you'll have 300k. And that's just from your Roth IRA. What a foundation you could set for yourself! And as the parent speaking for myself, I want my daughter, who's only ten months old right now, to have the freedom to pursue a passion and what she loves in life. I want her to have the funds to do that instead of scraping by at the beginning of her career in the corporate machine. While her contributions might not be enough to realistically give her that freedom, I know I’ll be much more likely to support her entrepreneurial endeavors knowing she has learned early how to invest and be intelligent and sensible with money. 

You can withdraw contributions at any time.

Now for the very pragmatic reasons to start a Roth for your kid. One great benefit is that contributions can with withdrawn for any reason without any tax consequences. No penalty, no tax. So if your child wants to make a down payment on a house in 20 years, he is free to take out those contributions. However, this doesn't apply to earnings on those contributions. For earnings, the value of the account above all the contributions added up, taking this out of the account would be considered an unqualified distribution and be subject to 10% penalty and income tax, assuming she's younger than 59 ½ and the distributions are not exempt.  

Exemptions

And this brings me to the exemptions, which can be pretty powerful. Your child will be able to withdraw earnings from their Roth IRA to pay for qualified education expenses such as tuition, books, and fees. This will only be penalty-free, not tax-free. Another exemption is for your child’s first house. They can take out up to10k fully tax and penalty-free as a down payment for their first home. And the other minor exemption from the SECURE act is that you can take out 5k penalty-free, not tax-free, for birth or adoption costs. 

So how do you open one?

So, how do we start a Roth IRA for our kids? The first thing you’ll need to do is open a custodial Roth IRA. Your child cannot open their own IRA until they are adults in your state, so either 21 or 18. Now, not all brokerages offer custodial Roth IRAs. But the major ones do, like Schwab, vanguard, and fidelity. So you will control the investments and decisions until your child is an adult, at which point it will be transferred into their name. 

Your child needs earned income

This is usually the biggest roadblock. Your child needs to earn a reasonable earned income reportable to the IRS. When I say reasonable, I mean you can’t have your child come into the office with you one day to work for you and then pay them 30k. Plus, 30k is well above contribution limits. But they do need earned income on a W2 or from self-employment.

The same rules apply to kids as adults regarding income limits. But one cool thing is that you, as the parents, can match their earned income and make the contribution yourself. However, the total contribution can never be more than the earned income. 

One popular move is the following: say your child earns 3000 dollars over the summer as a lifeguard. Maybe they only put $1,500 into the Roth and spent the rest. You and your daughter had an agreement that you’ll put in 50% of her total earned income. So you could contribute the other 1500 for her. 

Finally, it makes a lot of tax sense. Your child’s going to be making likely less than the 2021 standard deduction of 12,550 dollars, so they are essentially earning tax-free income, then investing it, and eventually taking it out completely tax-free. 

Okay, so are there downsides?

There are not any downsides, per se. I would caution you not to try and contribute income that your child doesn’t truly earn because it could come back to bite you with nasty penalties. 

Bottom Line

Roth IRAs are a great vehicle, and getting one for your kid could help them gain financial literacy and offer them a rock-solid foundation for their future.