Double Your Child’s (or Grandchild’s) Retirement Savings with a Roth IRA

  by Shelley Seagler

Most people are aware of the compounding interest and the tax benefits of Roth IRAs, but few realize that they can open accounts on behalf of their children to maximize these benefits over a lifetime. Contributing a total of about $82,500 on behalf of a child in a Roth IRA between the ages of 10 and 25 could translate to more than $600,000 in additional account value by the time that child reaches 59 ½ years old, assuming a five percent average rate of return.

Free Download: Step-by-Step Guide to Opening a Roth IRA for a Child

In this article, we will look at the mechanics of Roth IRAs, how to open one for a child, the potential long-term benefits, and some investment options for the account.

What Are Roth IRAs?

Roth Individual Retirement Accounts, or Roth IRAs, are special retirement accounts that are funded with post-tax income. While you can’t deduct contributions on your income taxes, the capital in the account grows tax-free and you can make qualified tax-free withdrawals. You can also take out your contributions – but not the capital gains on those contributions – tax- and penalty-free at any time, as well as make certain withdrawals tax-free before retirement.

Roth IRAs are the most advantageous for those that believe that their taxable income will be higher in the future than it is when they make contributions. For example, lower income earners that pay little in taxes and/or young workers that could benefit from years of tax-free compounded growth tend to benefit the most. Roth IRAs may also appeal to those that want to leave tax-free assets to their heirs since there are no required minimum distributions.

The maximum annual contribution to a Roth IRA changes each year. In 2018, the maximum annual contribution is $5,500 per year for individuals under the age of 50 and making less than $189,000 for joint filers or $120,000 for single filers. Those making more than those amounts can make partial contributions. If you failed to reach the maximum in a given tax year, you can make a contribution for a given tax year until the April tax deadline of the next tax year.

Opening a Roth IRA for Children

A growing number of brokerages offer Roth IRA accounts designed for children. For example, the Fidelity Roth IRA for Kids lets parents maintain control over the account as a custodian and receive statements and other communications. When a child reaches the required age (which varies by state), all of the assets in the account are transferred into the child’s new account. There are no minimums and no annual fees – just $4.95 for online U.S. equity trades.

Free Download: Step-by-Step Guide to Opening a Roth IRA for a Child

The most important consideration for opening a Roth IRA for a child is that they must have earned money during that tax year. While they can contribute up to the amount that they earned, the work must be both at a reasonable rate and well-documented. You cannot count allowances or pay your child $500 for cleaning up the house, but you can pay them a modest amount and keep records of these amounts each year.

You can also make a tax-free gift to the child’s Roth IRA that counts against your limit on tax-free gifts made to a single person. While your child can still only contribute up to how much they have earned, tax-free gifts make it possible for them to keep some or all of their earnings and still save for retirement. The gift tax limit varies depending on the tax year. In 2018, the gift tax limit is $15,000, which is up from the $14,000 that has been in place since 2013.

Children’s Roth IRA accounts can be invested in the same way as adult Roth IRA accounts. For example, they can purchase mutual funds and exchange-traded funds (ETFs), including target date retirement funds, or choose to invest their own portfolios. You can even use stock options in these accounts, including strategies like the Snider Method, as a way to hedge against risk or generate an income-focused portfolio.

Potential Long-term Benefits

Let’s assume that your child begins saving $5,500 per year for retirement at age 25 with a five percent average annual rate of return. By age 59 ½, they would have accumulated $506,246 in their retirement account after 34 and a half years of saving.

Now, let’s assume that you opened an account for the child and started gifting them $5,500 per year after they turned 10 years old (when they could arguably “earn” that much money). Once they turned 25, they started making their own contributions. By age 59 ½, they would have accumulated $1,177,065 in their retirement account after 49 and a half years of saving.

That’s a $670,819 difference in final value at age 59 ½ in exchange for making $82,500 worth of gifts between the ages of 10 and 25!

Most people think of Roth IRAs as retirement accounts, but the child can use these funds to help finance many important life events:

  • Buying a House. Your children can withdraw funds to purchase a house before reaching the 59 ½ retirement age. According to the IRS guidelines, the money must be used as a down payment for closing costs and withdrawals are limited to $10,000.
  • Educational Expenses. Your children can withdraw money for college. While they must pay taxes on the earnings, there is no ten percent early withdrawal penalty if it’s put towards qualified educational expenses.
  • Emergency Situations. Your children can withdraw money in an emergency, but these withdrawals are subject to taxes on earnings plus a ten percent withdrawal fee.

The Bottom Line

Children’s Roth IRA accounts are a great way to help a child save for retirement, or other important life events, while teaching them about financial concepts. If your kids are already adults, keep in mind that the same rules and concepts can be applied to grandchildren. Talk about a great way to spoil the grandkids! By either encouraging them to make contributions or gifting them capital early on, you can more than double their retirement savings over the years at a relatively modest cost to you. These win-win benefits make children’s Roth IRAs important for families to consider.

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