You have worked throughout your career to create a life that supports you and your family. For many investors nearing retirement, their next goal is to continue to leverage their hard work by creating generational wealth. When you have accumulated a comfortable nest egg and are looking ahead to impact future generations, it can be challenging to know where to begin. In this series, we will be going over questions we hear from pre-retirees and retirees about how to set their children and grandchildren up for financial success. 

One question we often hear from clients and colleagues is:

Can I help my minor child/grandchild start saving now if they are employed? 

Often in these cases, the minor in question is employed by a family member through a small family-owned business. Alternatively, they may have a part time job locally where they earn an income. 

In either case, one option is to explore opening a Roth IRA for the employed minor to start investing early and growing their net worth. 

First, A Note: Prioritize Your Goals

It goes without saying that opening and contributing to a Roth IRA for a minor should come after your initial financial needs are met. Before pursuing this idea, ensure that you are on track for your own retirement and savings goals, have pursued college savings accounts (like 529 plans) for your children and/or grandchildren, and are ready to take the next step. 

Understanding Roth IRAs for Minors

Roth IRAs can be used by anyone with an earned income – age is not a limiting factor. That means that even your 10-year-old grandson who walks dogs in his neighborhood can contribute. “Earned income” is qualified as either income earned from a W-2 job, or income earned through a freelance job. 

Minors can fall into either of these categories. In order to contribute, the minor would have to report earnings to the IRS and pay applicable income taxes. Once the account has been opened, you can choose to contribute, as well. However, the total amount contributed cannot exceed the total amount of earned income in a year, or the Roth IRA contribution maximum ($6,000 for those under age 50 as of 2021) – whichever is the lesser figure. 

For example, if your grandson has a net earned income of $500 walking dogs this year (good for him!) and contributes $250 – you cannot contribute $5,750 to “max out” the account. The total annual contribution limit cannot exceed his earned income of $500. 

Setting Up the Account

To set up a Roth IRA for a minor, you would open a Custodial Roth IRA. Note that not all financial institutions offer this type of account, and that the laws for opening and initially funding the account differ depending on your state of residency. It is wise to consult your financial advisor for assistance. 

What Are The Benefits? 

Roth IRAs are funded with after tax money. If a minor is making an income, it is usually not subject to a high-income tax bracket. Once their income has been taxed, and funds have been contributed to the Roth IRA, those investments continue to grow tax free. 

Finally, a minor who has a Roth IRA is able to use those funds in many different ways. Roth IRA rules for distributions aren’t as strict as other retirement-saving vehicles. Distributions can be taken at any time for any reason, but may be subject to tax penalties unless they are taken for the following reasons:

1. $10,000 or less of contributions and interest can be taken out of the account (as long as it has been open and funded for five years) to use for a first-time homebuyer down payment.
2. College expenses can be covered with funds from a Roth IRA (although distributions in this case may be subject to regular income taxes). Of course, remember that just because you can does not mean you should! A 529 Plan is usually your best course of action for college saving. 
3. Deposits made (not including interest, dividends, or capital gains) can be withdrawn at any time for any reason penalty free. This can help your young investor build up an emergency fund early as long as a portion of the contributions are left uninvested. 
4. The account owner can continue to contribute to the fund until they retire and take distributions to support their retirement income penalty-free and tax-free after age 59½. 

Note: Don’t Fund Immediately!

If you are ready to open a Custodial Roth IRA, wait until tax season to fund the account for the previous year’s contribution. This will help you to ensure you are within contribution limits based on the taxable income the minor is reporting for the previous year. It is also wise to keep in mind that your brokerage firm will likely have questions about this account – so start early! Do not wait until April 15th to contribute, file earlier in the first quarter of the year.