Starting a Roth IRA for a Child or Grandchild

This Early Financial Decision Could Prove Profoundly Positive Over Time

By PAUL TAGHIBAGI | Special to the Palisadian-Post

Do you have a child or grandchild earning income? That after-school or summer job might present a great savings opportunity for that minor.

Many people wish they had begun saving for retirement sooner. Imagine how your child or grandchild’s lifetime retirement savings can improve by starting as soon as possible.

Here is a little math to illustrate the potential: Suppose $1,000 goes into a Roth IRA when a child is 17, with $100 per month going into the account thereafter. Suppose the IRA compounds annually and returns 7% a year. After 45 years of saving and investing just $100 a month with a $1,000 lump sum to start, that IRA will contain $363,902 when they turn 62.

From very little investment effort, a considerable sum might arise over time. In reality, that sum might grow to be much greater than these calculations suggest because when that young adult grows older, he or she may contribute much more than the equivalent of $100 a month to the IRA.

The basic rules for creating a custodial Roth IRA for a minor are simple. The child must have earned income. The IRA contribution cannot exceed the child’s yearly earnings. (If the child has earned more than the yearly contribution limit for the Roth IRA, the maximum may be contributed. The maximum contribution for 2019 is $6,000.) If you prefer you can give the child the money to contribute.

Some fine print must be understood, though. The income must have been earned in connection with a legitimate business activity—it cannot be paid out in exchange for household chores. The business involved must define the child worker as an employee for federal tax purposes. Also, the income that the child earns must be reasonable in view of the job performed or the services rendered.

The potential tax advantages of a Roth IRA are profound. Earnings in a Roth IRA grow tax free and may be withdrawn once the IRA owner is age 59½ and has owned the IRA for five years. If your child invests steadily he or she could retire with a tax-free retirement fund that might be six or seven figures large.

Even a 25-year-old who contributes $5,000 a year to a Roth IRA earning 8% for 40 years is positioned to have about $1.4 million at age 65, and all of it may be withdrawn tax free if IRS rules are followed.

You may also realize a tax perk. If you make the initial contribution to the Roth IRA as a parent or grandparent, that money can count as a gift within your $15,000 yearly gift tax exclusion ($30,000 for a married couple).

Later in life, the Roth IRA assets may be useful in multiple ways. Did you know up to 100% of Roth IRA contributions may be withdrawn by a Roth IRA owner at any age, without any tax penalty? This option offers a young IRA owner a potential financial resource in an emergency.

Even though contributions may be withdrawn without penalties and taxes, any earnings withdrawn prematurely may be subject to taxes and a 10% IRS early withdrawal penalty. There is a notable exception to this: Up to $10,000 of earnings can be taken out of a Roth IRA tax free and penalty free at any time if the money is used to buy a first home.

A Roth IRA might give your child or grandchild a chance at a great financial start. Talk to the financial professional you know and trust about opening one.

Paul Taghibagi may be reached at 310-712-2323 or pt@seia.com. For more information, visit seia.com/bio/paul-taghibagi.