How To Make Roth IRA Contributions for Your Child In 2022

Retirement Planning

Parents want the best for their kids and are often worried about whether they can fulfill their needs, especially their financial security. A Pew Research Center report states that American parents particularly worry about the financial future of their younger generations. The report specifies that a majority of people (nearly 68%) believe their children will be in a financially weaker position than they are. This is because most children, whether teenagers or younger, rarely spend any time worrying about their retirement financial security. They are busy juggling school, assignments, extracurricular activities, and other adolescent challenges, and saving for retirement might not be their priority. Further, retirement is still a far-sighted goal for them since they are young and is not at the top of their to-do list. However, this does not imply that parents, grandparents, and other family members cannot plan for the financial security of their kids. Parents can jumpstart the journey of their child’s retirement savings by choosing effective saving mediums in the present.

One such way to give a head start to your child is through a Roth IRA (Individual Retirement Account). If you are wondering – can I open a Roth IRA for my child? The answer is – Yes. A Roth IRA is one of the strongest wealth-building tools you can set up for your child because it offers the maximum tax advantages between the accumulation phase and the withdrawal period during retirement. A Roth IRA can help secure your child’s financial future while teaching valuable lessons like financial discipline and more. If you deposit $10,000 today in your child’s Roth IRA, your funds earn an average 8% return each year. In 40 years from now, your child will have $217,000 in their Roth IRA, assuming they do not make any contribution to the account. If you wish to learn more about how a Roth IRA might fit in your retirement savings strategy for your child, reach out to a professional advisor who can guide you on the same.

If you wish to know more on how parents can contribute to a Roth IRA for their child, here are some insights that can help you make a sound decision:

What is a Roth IRA?

A Roth IRA is a type of individual retirement account that allows you to contribute after-tax dollars and earn tax-free returns on your money while also availing tax-exempt withdrawals, subject to fulfillment of some conditions. In simple terms, you can contribute money in a Roth IRA (after deducting taxes), invest the sum across different investment options (stocks, bonds, index funds, mutual funds, etc.) to earn tax-free returns and get tax-exempt withdrawals during retirement. However, to get tax-free withdrawals from a Roth IRA, you should hold the account for at least five years and draw your funds at the age of 59.5 years or more. If you meet these conditions, your Roth IRA withdrawals will be classified as qualified and tax-exempt.

A Roth IRA is not considered a prime saving vehicle for kids, but its benefits are being recognized as one of the most advantageous for children, especially those who start earning at a younger age. A Roth IRA is a suitable savings vehicle for kids because children have decades to allow their money to grow with the power of compounding. Moreover, these accounts offer flexibility in terms of withdrawals and usage of funds.

Roth IRA for children

There are no age restrictions in a Roth IRA. Anyone, irrespective of age, can contribute to a Roth IRA, provided they have an earned income. According to the IRS (Internal Revenue Service), all taxable wages and income received from your work are called earned income. So, assuming your child is 15 years old and earns some money by working as a part-time babysitter. You or another adult (responsible for the child) can open a custodial Roth IRA for the minor child at an authorized financial institution. The account will be managed by an adult (including decisions about annual contributions, distributions, and investments) until the child is legally eligible to control the account. Typically, the legal age can vary per the residential state of the child. In most cases, a child can take control over the custodial Roth IRA after 18 or 21 years. However, even when the adult holds the managing power of the Roth IRA, the child remains the beneficial account owner, and the Roth IRA sum should be used for the benefit of the child only.

For instance, your 15-year-old child earns $4,000 each year as a babysitter. If this money is in a Roth IRA that generates a 10% annual return and your child continues to save $4,000 each year in the account, your kid can achieve the golden figure of $1 million before they turn 55. If your child follows the withdrawal rules and withdraws the Roth IRA balance after the age of 59.5, they can get every penny of their savings 100% tax-free. However, in the future, your child may need much more than $1 million for a financially secure retirement. If they earn and save more than $4,000 annually in their Roth IRA, they can accumulate a much larger retirement corpus than $1 million only because you began saving in their Roth IRA early. If your child has other financial requirements, such as funding college expenses or buying a new home, the Roth IRA contributions can help accumulate sufficient wealth to support these financial goals. There are no restrictions on the usage of money from a Roth IRA. Hence, your child has the power to use the funds as required. There are no Required Minimum Distributions (RMDs) (the IRS-imposed mandatory distributions after age 72) in a Roth IRA. The absence of RMDs means your child’s Roth IRA savings can grow exponentially over a long period.

That said, it is critical to remember that your child can contribute to a Roth IRA only if they have an earned income. Money from allowance (even if the child works for it), cash gifts, investment returns, etc., do not account for earned income and cannot be contributed in a Roth IRA. However, if you own a business, your child can do work-appropriate tasks for you at reasonable wages.

If your child has not started working yet, starting a Roth IRA can be a fruitful step towards building a financially secure future. Your child can consider simple jobs like dance training, mowing, babysitting, modeling, tutoring, etc., to start earning an income from an early age. You can even open a Roth IRA for a toddler if the child has an earned income from a profession, say modeling. It is important to note that your earned income is separate and cannot substitute your child’s earned income in terms of Roth IRA.

Roth IRA contributions, penalty, and tax

Like any other Roth IRA, even the Roth IRA for your child has a maximum contribution limit. For 2022, $6,000 is the maximum contribution permissible for those younger than 55 years, and $7,000 is the maximum contribution limit for those older than 55 years. However, if the earned income is lower than the maximum contribution limit, a person can only contribute the earned income amount. For instance, if your child gets $4,000 in 2022 by doing work, he can only put $4,000 in the Roth IRA and not $6,000 for 2022. For any contributions above the limit, the IRS levies a 6% penalty every year until you correct the error.

If your child is not filing a tax form that covers the annual earned income, consider keeping a written record of the earned income of the child. Keep all receipts and information, such as type of work done, period of work, employer (for whom the work is done), and payment received, handy in case the IRS questions.

Can parents contribute to a Roth IRA for a child?

Yes, as parents, you can contribute to a Roth IRA in your child’s name. Contributing annually to your child’s Roth IRA is a much wiser gift to give them. It can be challenging to convince a growing kid to hand over their earned money for future financial security. Despite the potential of a Roth IRA to accumulate significant savings, keeping money in a Roth IRA might not be the first choice for a child who wants to spend money on buying smartphones, watching movies, paying for college, buying a car, etc.

Hence, if you fail to convince your child to contribute money in a Roth IRA or if you want to allow your child to have fun using their own money, you can permit this while still contributing to their Roth IRA. As long as the child has earned income that qualifies for Roth IRA contributions, there is no weightage for who makes the actual contribution. For instance, if your child earns $2,000 at a summer job, you could allow them to use that money for anything they like while making an equal contribution of $2,000 in their Roth IRA from your money. You can also offer to contribute only a percentage of what your child earns, such as 70%, 50%, etc.

The person who contributes does not matter. As long as the contribution comes from an earned income and your child can justify earning the same sum, you can contribute to a Roth IRA. Your contribution to a custodial Roth IRA cannot exceed the earned income of your kid. For example, if your son only made $3,000 from selling ice cream in the summer camp, you can only make an equivalent or a lesser contribution to their Roth IRA from your money. The contribution you make is for your child’s Roth IRA, and you do not get any tax benefit from it. You can contribute up to the maximum of your contribution limit, subject to your earned income. So, if your earned income in 2022 is $10,000 and your child gets $3,000, you can contribute $6,000 in your Roth IRA if you are under the age of 50; and $7,000 if you are over 50 years. Along with this, you could reward your child for working hard and make a contribution of $3,000 in their Roth IRA to match their eligible Roth IRA contributions for 2022.

However, irrespective of who contributes to the custodial Roth IRA, it is advisable to educate your child about the Roth IRA, its functions, investment options, contribution limits, penalties, withdrawal criteria, etc. If you do not educate your child about a Roth IRA, you may risk the contributions when your child takes control of the account. If you are thinking about how much to save for a child, you could consider contributing only a limited sum to the custodian Roth IRA and encourage your child to make a specific shared contribution, enabling them to learn financial lessons that can last a lifetime.

Advantages of having a Roth IRA for your kid

A Roth IRA is a smart tax-advantaged savings account. Specifically for kids, opening a Roth IRA offers the following benefits:

  1. Financial literacy: Opening an IRA for your child helps them learn valuable financial lessons. They understand the importance of earning, saving, and investing wisely for future financial security. They learn to see the bigger picture and comprehend important financial aspects like the power of compounding, investing in different assets, the relevance of investment risk, etc.
  2. Wealth building: Whether creating a retirement corpus or saving to pay for their education expenses, a Roth IRA for kids supports wealth accumulation in the long term. The earlier you start contributing to a Roth IRA, the greater is the power of the account to build a significantly large nest egg for your child.
  3. Flexibility in terms of using funds: A Roth IRA does not impose any restrictions on the usage of funds. The balance of the custodian Roth IRA can be used to pay for the child’s education expenses, support a financial emergency involving the child, buy a home for the child, or fund a retirement corpus.
  4. Tax savings: Unlike traditional IRAs, Roth IRAs require after-tax contributions. This means that your child or you cannot claim any tax deductions in the present for the contributions made to a Roth IRA. This works well for custodian Roth IRAs because, in their younger years, children usually have low annual earnings. Hence, little or no income tax is applicable. However, in the future, when they grow up and eventually begin taking distributions, their income might be subjected to a high tax rate. By opening a Roth IRA for your child now, you lower their future tax implications as they can withdraw their Roth IRA balance 100% tax-free if they meet the 5-year holding rule and the 59.5 years age restriction.

To summarize

Opening a Roth IRA can be the perfect gift for your child, enabling them to take advantage of tax-free money growth from a young age. Moreover, this helps build financial discipline and a healthy foundation for their future. Even though they might not be too excited about the idea of a Roth IRA, they are likely to be highly grateful to you many years from now. If you want more clarity on how to effectively fund a Roth IRA for your child, you can get in touch with a professional financial advisor.