Can I Open A Roth IRA For My Child?
Parents always want their children to succeed financially so they do everything they can to set them up for a good future. One of the options for parents is to set up a Roth IRA and we have a lot of parents that ask us if they are allowed to establish one on behalf of their son or daughter. You can, as long as they have earned income. This can be a
Parents will often ask us: “What type of account can I setup for my kids that will help them to get a head start financially in life"?”. One of the most powerful wealth building tools that you can setup for your children is a Roth IRA because all of accumulation between now and when they withdrawal it in retirement will be all tax free. If your child has $10,000 in their Roth IRA today, assuming they never make another deposit to the account, and it earns 8% per year, 40 years from now the account balance would be $217,000.
Contribution Limits
The maximum contribution that an individual under that age of 50 can make to a Roth IRA in 2022 is the LESSER of:
$6,000
100% of earned income
For most children between the age of 15 and 21, their Roth IRA contributions tend to be capped by the amount of their earned income. The most common sources of earned income for young adults within this age range are:
Part-time employment
Summer jobs
Paid internships
Wages from parent owned company
If they add up all of their W-2's at the end of the year and they total $3,000, the maximum contribution that you can make to their Roth IRA for that tax year is $3,000.
Roth IRA's for Minors
If you child is under the age of 18, you can still establish a Roth IRA for them. However, it will be considered a "custodial IRA". Since minors cannot enter into contracts, you as the parent serve as the custodian to their account. You will need to sign all of the forms to setup the account and select the investment allocation for the IRA. It's important to understand that even though you are listed as a custodian on the account, all contributions made to the account belong 100% to the child. Once the child turns age 18, they have full control over the account.
Age 18+
If the child is age 18 or older, they will be required to sign the forms to setup the Roth IRA and it's usually a good opportunity to introduce them to the investing world. We encourage our clients to bring their children to the meeting to establish the account so they can learn about investing, stocks, bonds, the benefits of compounded interest, and the stock market in general. It's a great learning experience.
Contribution Deadline & Tax Filing
The deadline to make a Roth IRA contribution is April 15th following the end of the calendar year. We often get the question: "Does my child need to file a tax return to make a Roth IRA contribution?" The answer is "no". If their taxable income is below the threshold that would otherwise require them to file a tax return, they are not required to file a tax return just because a Roth IRA was funded in their name.
Distribution Options
While many of parents establish Roth IRA’s for their children to give them a head start on saving for retirement, these accounts can be used to support other financial goals as well. Roth contributions are made with after tax dollars. The main benefit of having a Roth IRA is if withdrawals are made after the account has been established for 5 years and the IRA owner has obtained age 59½, there is no tax paid on the investment earnings distributed from the account.
If you distribute the investment earnings from a Roth IRA before reaching age 59½, the account owner has to pay income tax and a 10% early withdrawal penalty on the amount distributed. However, income taxes and penalties only apply to the “earnings” portion of the account. The contributions, since they were made with after tax dollar, can be withdrawal from the Roth IRA at any time without having to pay income taxes or penalties.
Example: I deposit $5,000 to my daughters Roth IRA and four years from now the account balance is $9,000. My daughter wants to buy a house but is having trouble coming up with the money for the down payment. She can withdrawal $5,000 out of her Roth IRA without having to pay taxes or penalties since that amount represents the after tax contributions that were made to the account. The $4,000 that represents the earnings portion of the account can remain in the account and continue to accumulate tax-free. Not only did I provide my daughter with a head start on her retirement savings but I was also able to help her with the purchase of her first house.
We have seen clients use this flexible withdrawal strategy to help their children pay for their wedding, pay for college, pay off student loans, and to purchase their first house.
Not Limited To Just Your Children
This wealth accumulate strategy is not limited to just your children. We have had grandparents fund Roth IRA's for their grandchildren and aunts fund Roth IRA's for their nephews. They do not have to be listed as a dependent on your tax return to establish a custodial IRA. If you are funded a Roth IRA for a minor or a college student that is not your child, you may have to obtain the total amount of wages on their W-2 form from their parents or the student because the contribution could be capped based on what they made for the year.
Business Owners
Sometime we see business owners put their kids on payroll for the sole purpose of providing them with enough income to make the $6,000 contribution to their Roth IRA. Also, the child is usually in a lower tax bracket than their parents, so the wages earned by the child are typically taxed at a lower tax rate. A special note with this strategy, you have to be able to justify the wages being paid to your kids if the IRS or DOL comes knocking at your door.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Need to Know College Savings Strategies
Our newsletter this quarter is dedicated to helping families plan for what has become a life-altering cost of paying for college. But do not fear, there are simple things you can do to boost your children's college fund. It is not news to anyone that over the past 30 years, the cost of college tuition and room & board at all levels has spun out of control.
college savings strategies
Our newsletter this quarter is dedicated to helping families plan for what has become a life-altering cost of paying for college. But do not fear, there are simple things you can do to boost your children's college fund. It is not news to anyone that over the past 30 years, the cost of college tuition and room & board at all levels has spun out of control. The year over year increase in the cost of tuition and fees since 1978 to date has far outpaced any reasonable rate of inflation, and demands a new look at college savings strategies. In the chart below, you will see the increase in the price of college tuition and fee versus other comparable expenses over the past 30 years. Its mind blowing!!
The need for College Savings Strategies - US Inflation Image
Fund A 529 Account*
As far as college savings strategies go, there are very few options that beat 529 accounts as a savings vehicle for college. In these accounts you make after tax contribution to the account and when the amounts are withdrawn, as long as those withdrawals are attributed to a qualified college expenses, the earnings generated by the account are tax free. Depending on the state you live in you may be eligible to receive a state tax deduction for contribution up to specified dollar amount. In New York, single filers receive a NYS tax deduction up to $5,000 and married filing joint $10,000.
Also for financial aid purposes these account are looked at very favorably in the EFC (Expected Family Contribution) calculation. They are looked at by FASFA as an asset of the "parent" not the asset of the "child". There are many contribution and withdrawal strategies associated with these accounts that can produce big tax benefits for individuals accumulating savings for themselves or their children.
Roth IRAs Are Not Just For Retirement
When clients have the dual goal of saving for retirement and saving for college, the Roth IRA is often times a great option. Even if you make too much to contribute directly to a Roth, you can implement a "non-deductible IRA to Roth IRA conversion strategy" that will allow you to still get money into a Roth IRA.
Contributions to Roth IRAs are made with after tax dollars but unlike a traditional IRA if you hold a Roth IRA for at least 5 years and make withdrawals after age 59 1/2 you pay no tax on the earnings.
Here is one college savings strategy technique: You are allowed at any time and at any age to withdrawal the contribution portion of your account balance from a Roth IRA tax and penalty free. For example, if I contribute $5,000 to a Roth IRA and 5 years later it is worth $10,000, I can contact my IRA provider and request that they distribute just my basis ($5,000) and leave the earnings in the account to continue to accumulate tax free. You can then use that basis distribution to fund college expenses but the earnings in the Roth IRA continue to accumulate tax free.
Maximize Your Financial Aid
There are strategies that can be implemented leading up to the filing of the FASFA form that can increase that amount of financial aid that you receive. When you apply for financial aid, FASFA has a complex EFC calculation that takes a snapshot of your assets and income to determine how much financial aid you will qualify for. There are ways to shift assets and shelter income from this calculation that can save individuals and families thousands of dollars when it come to paying for college. Here are a few of the strategies that can help to improve a EFC calculation:
Save money in the parents or grandparents name, not the childs name
Pay off consumer debt, such as credit cards and auto loans
Spend down the students asset and income first
Accelerate necessary expenses (such as computer purchase) to reduce cash
Minimize capital gains
Maximize your contributions to a retirement plan
Do not withdrawal money from a retirement plan to pay for college
Ask grandparents to wait to give grandchildren money until after college
Trust funds are generally ineffective at sheltering money from EFC
Prepay your mortgage
Contribute to 529 plans owned by the parent or grandparent
Choose the date to submit the FASFA carefully
Michael Ruger
About Michael...
Hi, Im Michael Ruger. Im the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
