My baby boomer clients are finally starting to grasp the concept of the tax-free benefits of the Roth IRA. So much in fact that they want to make sure that their kids start a Roth IRA and, in some cases, even their grandchildren.
I even had one grandfather who wanted to set up a Roth IRA for his 5-year-old grandson. While giving your kids the benefit of tax-free savings sounds sweet, there are some key rules when it comes to Roth IRAs for minors.
Here’s what you need to know about how your kids can enjoy tax-free money. Be sure to check out the rest of the Roth IRA rules.
Roth IRA For Minors
Amazingly, there is no minimum age requirement to open a Roth IRA. The only requirement is that the child have “earned income”. What defines earned income? According to the IRS.gov website:
Earned income includes all the taxable income and wages you get from working. There are two ways to get earned income: You work for someone who pays you or you work in a business you own.
Does a paper route count? Sure can. What about household chores? That’s a gray area, but most tax experts lean towards no. (Be sure to always ask your tax professional). What about child actors? Absolutely. I think that means that all 8 kids of John and Kate plus 8 could start a Roth IRA. I just hope they have a good financial advisor 🙂
Other items to note is that the child will only be able to contribute to a Roth as much as they earn. The 2015 limits are $5,000 but if the child only earns $2,000 for the year, that’s all they’ll be able to put in.
Who’s the Owner?
Depending on where you go to open the Roth IRA, there may be different requirements. When I worked for my previous firm, I had a client whose 16-year-old working son wanted to start a Roth IRA. My firm allowed it, but the father had to sign for him. Once the child celebrates his 18th birthday, the Roth IRA is officially his. (We’ll talk more about that in a bit).
Drawbacks of Roth IRA’s for Kids
Hard to believe there are any drawbacks to tax-free money, but there is one. The only drawback for opening a Roth IRA in the name of a minor is that the ownership of the account passes on to the child when he or she attains maturity.
That means that at the age of 18, the child (now adult) can do with the money whatever they choose. I”ll let your imagination take over on what an 18 year would do with a windfall of money.
Can You Just Open a Roth IRA for the Child?
After funding their retirement needs, many wish to pass on any remaining to their heirs. But for some, they wish that we could have some control when their heirs could get the money. I once had a reader that wanted to know how he could give his grandson the tax-free benefit of the Roth IRA. In my opinion, this is one cool grandfather.
The reader was roughly 60 years of age and wanted to open a Roth IRA for his five-year-old grandson. He wanted to make a $1,000 contribution into a Roth IRA thinking that the grandson would not be able to touch the money until he was age 60, and then he could benefit from the tax-free growth that the Roth IRA provides.
Just to give you an idea, if $1,000 were to earn on average 8% in a stock-like investment over the course of 55 years, it would grow to be around $101,000. The grandson would then have roughly $100,000 of tax-free money waiting for him at retirement. (At least that’s what the grandfather was hoping for).
While I appreciate the tactic that the grandfather was trying to implement, we do incur a bit of a problem. Since the grandson does not have any earned income, he would not be able to start a Roth IRA. Bummer.
After the initial attempt to pass on to grandson didn’t work out, he inquired about a different approach. He wanted to know if he could open a Roth IRA for himself and then make the grandson the sole beneficiary. Thinking again that the grandson could not touch the money until age 60.
Unfortunately, in that scenario, when the grandfather passes away the grandson would inherit the account and would have access to the money immediately, and would not have to wait until age 60. In addition, the grandson would be required to take out the required minimum distributions as a non-spousal beneficiary. Unfortunately, that idea did not work either. (The grandfather was still working at this time. If he was not and didn’t have earned income, he would not be able to open a Roth.)
If the grandfather would wait until the grandson actually had the earned income, he could then open up a Roth IRA in the child’s name. The only downside is that the child would have access to the funds and could withdraw them at any time possibly subject to tax and penalty. But if the child was educated on the tax-free benefit waiting for him at retirement, then the grandfather’s wishes may be achieved.
Where to Open an Account
As you can see, if you know the rules, your kids could benefit from the Roth IRA sooner than later. When your child starts receiving earned income, explain the benefits of the Roth IRA and get them excited. You can even help them get started.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute specific individualized tax, legal or investment advice. We suggest that you discuss your specific tax issues with a qualified tax or legal advisor.