You’ve probably heard of a traditional IRA and a Roth IRA, and at least a few of the differences between them. But what about the custodial Roth IRA? This savings plan is becoming more popular these days—and for good reason. If you’re wondering “what exactly is a custodial Roth IRA?” then we’ve got the answers you need. 

Let’s take a look at this unique IRA and what sets it apart from its peers.

What Is a Custodial Roth IRA?

A custodial Roth IRA is an account that you use to save for retirement. It’s an individual retirement account (IRA) in which you can invest your money and then take it out later to use for your retirement.

The key difference between a custodial Roth IRA and other IRAs is that, with a custodial Roth IRA, you make contributions on behalf of someone else—usually a young child or minor—who will eventually be able to withdraw the funds when they turn 59½ years old. The money isn’t taxed until it’s withdrawn from the account, so if your child earns interest on those contributions when they’re young, they won’t have to pay taxes on any income earned until they withdraw their funds in retirement. This means that your child has more money available for them once they reach retirement age!

Benefits of Starting a Child’s Roth IRA 

Many parents want to make sure their children are financially secure when they grow up. Setting up a Roth IRA for your child can be a great way to help them build wealth for their future. 

There are many benefits to starting a child’s Roth IRA, including:

Financial Literacy 

A major benefit of starting a child’s Roth IRA is that you can use this as an opportunity to teach your child about financial literacy. You can start by explaining how compound interest works and how it will help their investments grow over time. 

It will also help them learn about saving money and investing in the future. By setting up an account for your child and showing them how to use it responsibly, you’ll be giving them a head start on building good habits that will last throughout adulthood and beyond.

Children who are taught how to save money will learn how important it is to be responsible with their money as they grow older and start making more on their own. They’ll also learn how important it’s not just in terms of savings but also in terms of spending money wisely.

Tangible Uses

You can use funds from this type of account to pay for your child’s college tuition and other education-related costs without paying taxes on those withdrawals when they occur. Tapping into these funds can help offset some or all of those expenses so you don’t have to take out loans or incur debt during the process.

A custodial Roth IRA can also be used to pay for other qualified higher education expenses, such as room and board, books, and supplies—even computers and software. And you can use it for other educational costs that aren’t necessarily related to attending a postsecondary school, such as tutoring or special needs transportation services.

You can also use your child’s account as a way to diversify your family’s tax portfolio by investing in assets that aren’t in your own retirement accounts.

More Savings

Roth IRAs are funded with after-tax dollars, meaning you’ve already paid income taxes on the money that goes into the account. Because of this, your savings will be tax-free when you withdraw them in retirement—so you won’t pay any additional taxes on those funds.

The benefit of this is obvious: You can save more money. For example, if you put $5,000 into a Roth IRA and expect an average annual return of 6% over the next 30 years (which is comparable to historical averages), then your investment would grow to $32,000 by retirement age—five times as much as it would have grown to if it were in a traditional IRA or 401(k).

How Much Can I Put Into My Child’s Roth IRA?

The IRS has strict rules about how much money you can contribute to your child’s Roth IRA. This amount is based on their age and whether they have earned income. Currently, the maximum annual contribution allowed is $6,000.

You can make these contributions on behalf of your child from any taxable income you earn. The contribution doesn’t have to come from wages or salary; it could come from any other source of taxable income that you have.

If you want to make sure that you’re not accidentally contributing more than the legal limit, we recommend setting up an automatic monthly contribution plan, so you don’t have to remember when tax season comes around every year.

The Rules of Custodial Roth IRAs 

The rules for a custodial Roth IRA are similar to those for other Roth IRAs, but there are some key differences.

Here’s what you need to know about the rules of custodial Roth IRAs:

Eligibility

To open a custodial Roth IRA, you must be at least 18 years old and have legal custody of the child whose assets you want to invest in an account. You also need to have earned income equal to at least 50 percent of your adjusted gross income (AGI), which includes taxable wages, self-employment income and alimony. 

For example, if your AGI is $30,000 and you earn $6,000 from self-employment, then you must have earned at least $3,000 from self-employment in order to qualify for a contribution to a custodial Roth IRA on behalf of your child.

Contribution Limits

The contribution limits for a custodial Roth IRA are the same as those for an adult Roth IRA. You can contribute up to $6,000 per year, or up to 100% of your taxable compensation, whichever is less.

If you have a child aged 18 or older who earns taxable income, you can make Roth IRA contributions to their custodial Roth IRAs. However, the Roth IRA contribution limits are different: you can only contribute up to the amount of their earned income.

If you’re married and file jointly, your combined Roth IRA contributions cannot exceed $10,000 ($11,000 if over 50). This limit applies to each spouse’s IRA contributions and any spousal re-characterizations of traditional IRAs into Roth IRAs.

Tax Implications

The tax implications of a custodial Roth IRA are the same as any other Roth IRA. The money in the account grows tax-free, and withdrawals from the account are tax-free when you reach age 59½.

There is one exception to this rule, however. If you withdraw your contributions (the money you put into the account) before you reach age 59½, those withdrawals will be taxed as ordinary income. In addition, if you take a withdrawal from your custodial Roth IRA that’s more than your original contribution, it will be subject to a 10% penalty tax on top of that.

Switching to a Traditional Roth IRA

If you have a custodial Roth IRA, you may be wondering how to switch from your current account to a traditional IRA. Here’s how.

First, contact your financial institution and tell them that you want to convert your custodial account into a traditional one. They will ask for your Social Security number and other information about your account, so make sure that you have all of that ready. They may also ask if there are any penalties associated with the conversion.

Next, you’ll need to request that all of your assets be withdrawn from the custodial account and deposited into your new traditional IRA. This can take up to 60 days because of taxes and paperwork involved in moving funds from one place to another. 

Once this is done, you can start investing as normal in your new traditional IRA. But remember, any money invested in a Roth IRA is not taxed until retirement age (or earlier if there are special circumstances).

Withdrawals

The rules for withdrawals from a custodial Roth IRA are the same as for traditional IRAs. You can begin taking money out of your account at any time, but the longer you wait, the more money you’ll have to pay in taxes on it.

You’re allowed to withdraw contributions at any time without paying any taxes or penalties. The only restriction is that you must be 59½ years old or older before making a withdrawal.

The earnings on your contributions are subject to ordinary income tax as well as an additional 10% tax if you take money out before age 59 1/2 (unless it’s used to buy your first home or pay higher education expenses). It’s important to note that this 10% penalty is not waived if you’re using a Roth conversion ladder strategy, even though it might seem like your contributions were converted much earlier.

Types of IRAs for Kids

The Roth IRA for kids is a great way to get your child started on their path to retirement. There are two different types of IRAs you can use for your child. Here’s a look at each type of Roth IRA for kids and how it works.

Roth IRA

The Roth IRA is different from other types of IRAs because it doesn’t allow you to deduct contributions from your taxable income when you file your taxes (unlike traditional IRAs). 

But here’s why having a Roth IRA is still worth it: You can withdraw contributions at any time without paying any taxes or penalties — even if you’re younger than 59½ years old! However, if you withdraw earnings before that age, they’ll be subject to income tax plus a 10% penalty fee (unless an exception applies).

Traditional IRA

A traditional IRA is an individual retirement account that’s funded with pre-tax money. This means you don’t pay taxes on the money you contribute to your traditional IRA until you withdraw it during retirement. That’s why these accounts are sometimes called deductible IRAs—because you get a tax deduction for contributing to them each year.

You’ll have to pay income tax on any withdrawals from a traditional IRA, but they’re not subject to capital gains taxes or early withdrawal penalties like Roth IRAs are. Hopefully this helps you determine the benefits for Roth IRA’s for kids and yourself. Now let’s determine which is better?

Which is Better: Traditional or Roth IRA?

If you’re wondering whether a Traditional IRA or Roth IRA is right for you, there are a few things to consider.

With a traditional IRA, you can deduct your contributions from your taxable income now, but then they’ll be taxed when you withdraw them in retirement. With a Roth IRA, you pay taxes on your contributions now, but then they’re tax-free when you withdraw them in retirement.

If you have a high income and you plan on being in a higher tax bracket when you retire than you are now, then a Roth IRA may be more beneficial, since it will allow you to pay the current taxes on your contributions and avoid paying taxes later when they come out as income. But if that’s not the case for you—or if it will be difficult for some reason to contribute to an IRA during this current year—then it might be better for now just to contribute to a traditional IRA (which allows deductible contributions).

The Bottom Line

The custodial Roth IRA is a great idea for parents who want to start their kids off with a little tax-free money. Not only is it an opportunity to start teaching your children about smart money habits and investing, but it also sets them up with a sizable chunk of change when they are ready to move out on their own. 

If you’re a parent, the custodial Roth IRA can be a powerful savings tool. There’s never been a better time to get started, so do your research and see if it’s right for you! Contact The Budgetnista for more detail!  We have a variety of options for learning more tax tips. If you want to learn more about tax-savvy investment ideas, read our book, book with The Budgetnista or explore more financial resources and tools within the website.

About the Author Tiffany Aliche

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