How do Roth IRAs for Kids Work?

When we think about retirement accounts, kids don’t normally come to mind. But the truth is that a Roth IRA can actually be a great savings tool for children. It allows for potentially higher returns when compared to traditional savings accounts. Thanks to the magic of compound interest, contributions can grow for many decades leading up to retirement—and if they want to pull their money out before then, they’re welcome to it.

Here's a quick but thorough explainer on how Roth IRAs for kids work.

What is a Roth IRA?

Let’s first break down how Roth IRAs work. It’s a retirement savings account that’s funded with after-tax dollars. Unlike a 401(k) or traditional IRA, you won’t get a tax break on the money you put in, but it still has some key advantages. For one, you can withdraw your contributions at any time without incurring a tax bill. The other tax-advantaged accounts we just mentioned will hit you with a 10% penalty if you withdraw funds before age 59½. Distributions are also taxed as ordinary income—not so with a Roth IRA.

It's worth noting, however, that Roth IRA earnings (a.k.a. investment returns) are a different story. To avoid taxes and penalties here, you’ll need to have the account for at least five years. Folks who are under 59½  will also have to meet other IRS criteria to avoid being penalized for tapping their earnings. One exception is if you’re using up to $10,000 of Roth IRA earnings for a qualified first-time home purchase.

One other thing about IRAs is that they have contribution limits. In 2022, you can kick in up to $6,000 across all your IRAs; $7,000 if you’re 50 or older. Income thresholds also come into play with Roth IRAs. Contributions begin phasing out for folks who earn too much.

How do Kids Factor in?

It’s possible to open a custodial IRA for a child. This just means that an adult opens and manages the account for the child until they come of age. Meanwhile, kids can funnel their earned income right into the Roth IRA. It can then grow over time and accumulate a pool of cash they can use for all kinds of reasons—from saving for retirement to buying their first car to paying for college expenses.

The main rule is that they must have earned income to contribute. This can include cash they earn from babysitting jobs or mowing lawns in the neighborhood, or from legit W-2 employment like an after-school job. They can contribute up to the limit mentioned above or their total earned income for the year (whichever one is less). As a parent, you can also throw some cash into their Roth IRA. You’re allowed to match their contributions as long as the total doesn’t exceed your kiddo’s annual earned income.

Benefits of Opening a Roth IRA for Your Child

  • It enables your child to accumulate a pool of money that can be used for all kinds of expenses, including college or buying their first home.

  • It allows for higher potential returns when compared to regular savings accounts, which generally only return around 1%. From 2011 to 2022, the S&P 500 boasted an average annual return of over 14%.

  • It provides an opportunity to teach your child about saving and investing. The adult manages the account, so you can invite your child to participate with you as they get older.

  • If your child leaves a portion of their balance invested over the long haul, it could amount to a nice little retirement nest egg when the time comes

How to Open a Roth IRA for Your Child

Opening a Roth IRA for your kiddo isn’t all that different from opening one for yourself. You’ll first have to find a financial institution that offers custodial IRAs. (An experienced financial advisor can point you in the right direction.) From there, you can establish it yourself and begin making contributions on behalf of the minor. They’ll take ownership of the account when they come of age. FYI, this age varies by state.

Roth IRAs for kids require no minimum investments, so your child can start small and contribute whatever earned income they have. Meanwhile, the parent can explore whatever investment options the IRA provider has to offer.

Just bear in mind that your child may have a tax liability, depending on how much income they earn. They’ll be expected to file a tax return if their earnings exceed the standard tax deduction for the year. For 2022, that’s $12,950. The Roth IRA contribution limit is still the same, but it’s good to know. It’s also wise to encourage your child to maintain tidy records of their income. If they’re getting paid to walk a neighbor’s dog, for example, you can help them create invoices and keep these records organized for tax purposes—it’s a habit that will likely serve them well in adulthood.

Roth IRAs for children might be a little confusing, but they could make for a smart financial tool for your child. We’re here to break down the details if you need extra clarification.


AJ Grossan