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You may already be helping your children financially with allowance, gift money and, of course, food and shelter. But what about assisting them with their long-term financial goals?
Parents can help any child who earns money open a custodial IRA and start saving for retirement. Although retirement saving is not immediate gratification for a minor child, a custodial IRA can help open the door to investing, provide a lifetime of tax benefits and get your child strategizing about money from an early age.
What Is a Custodial IRA?
A custodial IRA, also known as a guardian IRA, is a retirement account set up for a minor child by their parent, grandparent, legal guardian or other adult. The child owns the account and the adult acts as custodian, managing the account on the child's behalf, until they reach adulthood―between ages 18 and 21 in most states. A custodial IRA may also be set up on behalf of a disabled child, family member or adult who is unable to manage finances on their own.
Here are a few items to note about custodial IRAs:
- A custodial IRA may be either a traditional or Roth IRA.
- It belongs to the child, not the parent.
- A custodian, typically a parent or guardian, manages the funds.
- A custodial IRA follows the same rules for contributions, taxes, early withdrawals and distributions as a regular IRA.
- It converts to a regular IRA without custodial oversight when the child becomes an adult.
What Is the Purpose of a Custodial IRA?
A custodial IRA helps your child get a head start on tax-advantaged retirement savings.
If you've ever taken a personal finance class, you've probably seen some version of a graphic that shows how much $1,000 invested in an IRA at age 15 would be worth at age 68 (spoiler: at an average growth rate of 8%, it would be worth $59,083). By putting their earnings into a custodial IRA early in life, your kids could actually live this dream.
To contribute to a custodial IRA, your child must have earned income—the money can come from a job or from "contract" work like babysitting or cleaning yards. The IRA funds don't have to come from your child: You can contribute your own money, as long as the total contribution doesn't exceed IRA contribution limits or your child's total earned income (whichever is less).
Should You Choose a Traditional or Roth IRA?
Choosing between a traditional and Roth IRA can be complicated for an adult. For a child, the calculus may be simpler. If your child has significant taxable earned income, they can reduce their tax liability by contributing to a traditional IRA and deducting the amount of their contribution on their tax return.
But, since most children and teens don't have enough income to need this tax savings, a Roth IRA may offer more compelling lifetime tax benefits. Although a Roth IRA is funded with after-tax dollars, the money grows tax-free for as long as it stays in the account. Withdrawals are then tax-free in retirement.
How Do You Open a Custodial IRA?
Many large financial companies offer custodial or guardian IRAs, including Charles Schwab and Fidelity.
Choose a provider and complete an application. You'll provide basic information on yourself and your child, including Social Security numbers, income and banking information.
The 2022 contribution limit for traditional or Roth IRAs is $6,000 or 100% of income earned for the year, whichever is less. If your child earned $1,500 this year, they can contribute up to $1,500 to an IRA.
When you complete the application, you'll nominate a successor custodian to manage the account if you pass away before your child reaches the age of majority. If your child should pass away, the account will pass to their estate.
A custodial IRA converts to a regular IRA when your child reaches the age of majority, sometime between 18 and 21 in most states. At this point, your child will complete paperwork to finalize the conversion from a custodial IRA to a regular IRA and assume full control of the account.
Ideally, your child will leave their IRA funds in place until they retire. However, they may be able to withdraw their money tax- and penalty-free to pay for qualifying college expenses or a first-time home purchase. They can withdraw their contributions from a Roth IRA penalty- and tax-free at any time, although any earnings they withdraw before reaching retirement age at 59½ may be subject to regular income tax and a 10% early withdrawal tax.
3 Reasons to Consider a Custodial IRA
Helping your child open and fund a custodial IRA is not mandatory, but it can provide your child with some valuable money-saving and educational tools. Here are a few:
Give Your Kids a Head Start on Retirement Savings
Opening a custodial IRA sets your kids on the right path toward long-term saving and investment. When they become adults, they'll already have a working retirement account with funds to build on.
Provide Lifelong Tax Advantages
Earnings on funds in a traditional IRA are tax free until the money is withdrawn in retirement. Money invested in a Roth IRA is tax-exempt for the life of the account as long as you follow the rules, and you don't pay taxes on earnings or qualifying withdrawals in retirement. These tax benefits are helpful at any stage of life, but you have more time to reap the benefits when you begin saving early.
Ease Your Child Into Investing
Opening a custodial IRA at an investment firm introduces the experience of investing money for long-term wealth. As custodian, you can help your kids navigate investment decisions while they grow their assets over time. But, unlike a regular investment account, retirement savings, including custodial IRAs, are not reported on the FAFSA financial aid form and will not affect your child's ability to qualify for financial aid.
The Bottom Line
A custodial IRA offers kids and parents a unique opportunity to begin saving for retirement early—and hopefully establish good habits they'll use for a lifetime.
Custodial IRAs are only one option for helping your kids develop strong money skills. You may also want to consider helping them open a regular savings account for emergency funds and short-term spending goals, funding a 529 to save for college and exploring a secured credit card to help them establish good credit. It's also never too early to check your child's credit report (if they have one) for signs of identity theft and sign them up for free credit monitoring, two more good money habits you can start early.