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Robert Bloink and William H. Byrnes

Retirement Planning > Saving for Retirement > IRAs

Don't Overlook Roth IRAs for Children and Grandchildren

By Robert Bloink By William H. Byrnes

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What You Need to Know

  • Roth IRAs are particularly attractive for younger savers due to the potential for significant tax-free growth.
  • Clients whose children and grandchildren worked summer jobs may be particularly interested in funding a Roth account.
  • However, it’s important to understand the basic mechanics of these accounts to avoid penalty taxes.

With that the end of summer — and start of a new school year — quickly approaching, now may be the perfect time to encourage a child or grandchild to jump-start their savings program and learn to manage their finances.

While retirement accounts are often overlooked as a savings option for the younger generations, Roth IRAs are particularly attractive for younger savers because of the potential for significant tax-free growth, potentially over a period of decades.

Clients whose children and grandchildren worked summer jobs may be particularly interested in funding a Roth account to save for retirement, college or even the purchase of a first home down the line. However, it’s important to understand the basic mechanics of these accounts to avoid penalty taxes.

Roth IRAs for Kids and Grandkids: The Basics

Many clients overlook the Roth IRA option for children and grandchildren because these Roth accounts are obviously geared toward retirement saving — and saving for retirement for a child almost always takes a backseat to saving for education. However, in reality, these accounts can provide a powerful savings tool.

The only restriction on funding an IRA is that the individual must have earned income for the year. In 2023, an individual under age 50 may contribute the lesser of (1) his or her earned income for the year or (2) $6,500. Therefore, if a child had a summer or part-time job that generates earned income, that child is eligible to open and contribute to a Roth IRA for the year.

If the child is a minor, the Roth IRA is technically established by the minor child’s parent or grandparent as a custodial account, with the adult acting as custodian and the minor as the account holder. Once the funds are transferred into the Roth account, the transfer is irrevocable (i.e., the funds cannot later be transferred into an account for another individual). Once the child is no longer a minor, the funds become theirs to control.

As long as the child has earned income, it does not matter from where the funds that are actually contributed to the account come — meaning that if the child earned $6,500 in 2023, a parent or grandparent can fund the Roth IRA for that child with $6,500 of the adult’s own money, allowing the child to keep his or her income.

Earned income is any taxable income earned by the child, including traditional W-2 wages from a summer job or even self-employment income earned from mowing lawns or babysitting. While the work itself may be casual, it is important to document the child’s earnings (even with something as basic as a spreadsheet) and file a tax return for the year the contribution is made. However, parents should hesitate to use a child’s allowance for basic household contributions as the basis for a Roth contribution to avoid a potential IRS challenge.

Can the Child Access the Roth Funds Before Retirement?

In general, Roth IRA contributions can be withdrawn at any time, so the child will not be subject to the harsh penalty taxes that apply to early withdrawals from traditional IRAs and 401(k)s. That’s because the Roth account is funded with after-tax dollars to begin with. Despite this general rule, a 10% penalty tax will apply to any Roth IRA earnings that are withdrawn within the first five years after the Roth IRA is established (unless an exception to the penalty applies).

The penalty tax (as well as typical income taxes) on Roth IRA earnings up to $10,000 can also be avoided if the account owner uses the funds to purchase his or her first home. The penalty on earnings is avoided if the funds are withdrawn to pay for qualified education expenses (however, earnings withdrawn within the initial five years after the account is established will be subject to traditional income tax).

Importantly, the actual funds that were contributed are not subject to the penalty or taxes upon withdrawal for any reason, and withdrawals from Roth IRAs are treated as first coming from the actual contributions.

Conclusion

Setting up a Roth IRA for a child can be a powerful way to teach the young person about the value of saving for the future. As summer winds down, now may be the perfect time for the adults in a child’s life to explore this savings option.

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Robert Bloink

William H. Byrnes

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