The earlier your children can start investing, the greater their opportunity to build a sizable nest egg for the future. A ROTH IRA is an individual tax-advantaged retirement account in which qualified withdrawals are tax-free, and growth within the account is tax-free.
ROTH IRAs are ideal for children because they have decades for their contributions to grow tax-free, and they offer tons of flexibility when it comes to contributions & withdrawals. There are no age restrictions for ROTH IRAs, so children of any age can contribute if they have earned income. The parent will need to open a custodial account for their child if they are under 18 (or 21 in some states).
Quick Facts about ROTH IRAs
There is no age limit – The obstacle to opening a ROTH IRA is income, not age. Custodial accounts can be opened for your child at any age.
Your child must have earned income – Without earned income, your child cannot contribute to a ROTH IRA. Earned income is defined by the IRS as taxable income and wages (Money earned from W-2 jobs or self-employment jobs).
There are limits to how much your child can contribute – The 2021 ROTH IRA contribution limit is $6,000 ($7,000 if age 50 or older), OR the total of earned income for the year. If your child earns $1,000 walking dogs for 2020, he or she can contribute up to $1,000 to their ROTH IRA.
The money contributed to a ROTH IRA can be withdrawn at any time and use for any expense your child may incur. Distributions of investment earnings may be taxed as income, penalized with a 10% early distribution tax or both. These two regulations make ROTH IRAs nice for kids who want easy access to their cash and parents who want to make sure some of that cash is saved for the future.
More time means more growth, and compound interest allows for the money to grow exponentially over a long period of time. A one-time contribution of $6,000 with NO additional contributions into a ROTH IRA will grow to about $200,000 in 60 years (Assuming 6% return and monthly compounding). Due to their being no tax break for putting money into the account, qualified distributions in retirement are tax-free. The ROTH IRAs tax treatment is more valuable when the time horizon is long and your child’s current tax rate is low. Most children’s earnings are low enough that they pay little to no income tax, meaning they avoid taxed on contributions as well.
Lastly, there are a few loopholes that can get your kid access to their investment earnings before age 59 1/2. After the ROTH IRA has been funded for five years, your child can withdraw up to $10,000 in earnings to buy a first home, tax & penalty free. ROTH IRA earnings can also be used for qualified education expenses such as college tuition. Earnings distributed would be taxed as income but there will be no penalty.