Between lunch money, allowance, and college savings, you’re already taking steps toward your child’s financial education. But how can you truly unlock your child’s financial freedom?
If you want to give your kids a financial head start, a custodial IRA can be a helpful tool to secure their financial future. If you’re unsure where to start, this article will cover all the basics that you need to know about opening up an IRA for your child.
What is a Custodial IRA?
A custodial IRA is a retirement account for minors. Usually opened by a legal guardian or parent, this account remains under the adult’s control until the child comes of age.
Opening a custodial IRA is a great tax planning strategy that also allows you to get your child started on a path toward building generational wealth.
Even if it feels like your little one is ages away from retiring, it’s never too early to start building their nest egg. Every preschooler or elementary-age child can benefit from saving toward retirement. The sooner you start, the better. That’s why a custodial IRA is an intelligent way to help your kids in their financial journey.
Custodial IRA: Roth vs. Traditional
A Roth and a traditional IRA are both saving accounts that help you set money aside for retirement. The main difference is that a Roth IRA takes care of tax payments now, so your money grows tax-free, while a traditional IRA uses pre-tax dollars and leaves tax payments for later in life.
Depending on your personal situation, there are pros and cons to each. The table below will come in handy while debating which type of account to open.
|Traditional IRA||Roth IRA|
|Contributions are tax deductible for that year||Not able to deduct from your taxes|
|Tax-deferred payments||Money grows tax-free|
|Before age 59 ½, withdrawing money will result in a 10% penalty||Contributions can be withdrawn before retirement without any penalties|
|After the age of 72, you must begin to make Required Minimum Distributions (RMDs)||You are never required to take out money|
Custodial IRA Rules
When you open a custodial IRA for your children, there are certain rules to follow. These rules are set in place to get the most out of your investment.
- All management is up to the parent/custodian
- As of 2022, the IRS contribution limit for Roth IRAs is $6000
- Your child must have taxable income
- Once your child turns 18, they assume management of their IRA
How to Open an IRA for Your Kids
Opening an IRA for your kids is a simple and easy process. Depending on which financial institution you choose, there may be slight differences when opening your child’s account. However, the process is pretty similar across the board.
Like when you open any other bank account, you will first need to choose the right financial institution for you. Once you’ve made that decision, gather your and your child’s personal information. This includes date of birth, social security number, and contact information.
You can go in person or online to open the account with this information. Once you’ve successfully opened your child’s IRA, you can begin depositing money, always keeping the IRS contribution limits in mind.
Best Banks to Open an IRA for Your Kids
While opening an IRA for your child, it’s important to choose the bank that’s the best fit for you and your family. There are a variety of options available, though many parents choose to open a custodial IRA through their financial advisor.
Some banks known for their long-term dependability are Charles Schwab, Fidelity, Goldman Sachs, and JP Morgan Chase. If you want to work with an investment advisor who manages your account, these banks are the best option for you. Their reputation and customer service make them a trusted choice among investors.
Thanks to modern technology, another popular choice these days is online brokerage. Often, account owners choose to pair these accounts with AI to assist in their portfolio creation and investment decisions. Some investor favorites are Robinhood, Webull, E-Trade, and Stash. With lower minimums and cheaper fees, online brokerages can offer a more hands-on approach to your child’s custodial IRA.
Benefits of Opening an IRA for Your Kids
Opening an IRA for your kids will open many doors and opportunities throughout life. Some of these include:
- Lifelong tax advantages
- Easy headstart on retirement
- Great way to start accumulating wealth at a young age
- Creating financial awareness and supporting their financial education
Custodial IRA vs. 529 – Is There a Right Choice?
Many parents go back and forth on whether to open a custodial IRA or a 529 for their children. While this may seem like a tough decision, with the right information, it can be simple.
The first step to making this choice is understanding the key differences between an IRA and a 529. A 529 uses after-tax dollars to save for your child’s college expenses. Its purpose is to set money aside to pay for your child’s college education, but it’s not tax deductible at the federal level. You may receive some tax benefits depending on which state plan you choose.
It’s also important to note that spending money from a 529 account comes with restrictions. To avoid penalties, you must use the funds for education-related expenses.
Unlike a 529, which always stays in the parent’s name, a Custodial IRA is transferred to your child once they turn 18. Contributions to your child’s IRA result in tax benefits to you as the parent. They offer greater freedom to use the funds as you or your adult child sees fit.
By using after-tax dollars, Roth IRAs grow your money tax-free. On the other hand, traditional IRAs allow you to pay taxes later when your child is ready to withdraw.
529 Rollover to Roth
As you already know, 529 plans are investment accounts that you can open on behalf of your child. In these accounts, your investments grow tax-free as long as you use the funds for educational purposes. But, what if you save more than what your child needs for college?
Starting in 2024, parents will be able to roll over any unused education funds from a child’s 529 to the same beneficiary’s Roth IRA. Some restrictions to keep in mind:
- There is a $35,000 lifetime cap on these transfers
- Rollovers are subject to the annual Roth IRA contribution limit – which, as of 2023, is $6,500
- The rollover can only be made to the 529 beneficiary’s Roth IRA
- The 529 needs to have been open for at least 15 years
- Contributions made within the last five years are not eligible for rollovers
Which to Choose?
There’s no right or wrong answer when choosing between a custodial IRA and a 529. It depends on your personal situation and your financial goals. A custodial IRA may be the best choice for you and your family if your objectives are to build generational wealth and reap the tax benefits. If saving for college is part of your financial plan, a 529 may be your best investment vehicle.
As a rule of thumb, it’s always best to consult your financial advisor before making these decisions.
Set Your Child Up for Financial Success
Opening a custodial IRA for your child can be one of the most forward-thinking steps you can take as a parent. It allows you to shave years off their financial learning curve and can result in tax benefits to you as a parent. With this tool, you can empower your child to build wealth from an early age and set them up with a solid financial foundation for years to come.