Investing in a Roth IRA for a Child

My Millennial money tips this month focus on financial flexibility, how to pick an index fund, and when to open a Roth IRA for a child

Personal finance author Katie Gatti Tassin has joked that her “biggest financial mistake in 2008 was being in eighth grade instead of buying real estate.”

*Editor’s Note: I originally published this article in my Millennial finance newsletter, which you also can get twice each month (for free) by adding your name here*

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Like many adults, you may bemoan the financial opportunities you missed due to unlucky timing. But even kids have one very powerful financial strategy available to them. They just need a little help from us.

You may know that, with enough earned income, you can contribute to your own individual retirement account (IRA). You may not have heard, though, that you also can invest in a Roth IRA for a child.

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How Does a Roth IRA Work? A Quick Review

The IRS describes an IRA as a “way to save for retirement that gives you tax advantages.” With a Roth IRA, in particular, you can’t deduct your contributions on your tax return. However, “if you satisfy the requirements, qualified distributions are tax-free.”

Now let’s apply these rules to your child.

In 2024, your son or daughter won’t owe any federal income taxes if they earn less than $14,600 (the standard deduction for a single filer). Typically, when you as an adult contribute to your own Roth IRA, you’ve already paid income taxes on that money.

But for your child, as financial advisor Meg Bartelt writes:

• The money can go in income-tax free (at least at the federal level, and possibly at the state level);
• After you invest it, it can grow tax-free; and
• eventually, it will be withdrawn tax-free.”

Here’s the most notable requirement for you to open a Roth IRA for a child: your son or daughter just needs earned income during the year.

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The Impact of Compound Growth From a Young Age

Investing at any age offers significant benefits due to the potential return you may earn. But the math behind compounding means that your longest-held investments have the highest growth potential (all other variables equal).

If you’re investing for retirement, for instance, starting as a teenager beats out starting as a mid-career professional. Let’s look at an example that Bartelt provides:

Assume in this case that her daughter invests $1,000 in her Roth IRA at age 14. Many people wouldn’t make the same $1,000 Roth IRA investment until age 34. Now also assume 8% average annual growth. By age 65 (a typical retirement age), that $1,000 has grown significantly larger with 20 extra years of compounding: $50,654 (age 14 investment) vs. $10,868 (age 34 investment). 

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Common Questions About Opening a Roth IRA for a Child

You probably have a lot of questions about how opening a Roth IRA for a child works.

The most common question that I’ve received relates to when you can start this type of investment. Usually, as I noted above, you’ve cleared the primary hurdle once your son or daughter earns income during that year. And, yes, that money can come from babysitting, mowing lawns, or any other income-generating work. If your child works formally for a company, then they should receive a W-2 tax form that documents the income.

If your child is less formally employed, though, you’ll need to document the income. You’ll want to track:

• The type of work completed;
• The beneficiary of the work (for example, a person or organization);
• The dollar amounts earned;
• The dates on which the work took place.

Here’s another common question: is my child’s Roth IRA the same as my own Roth IRA?

Your child’s Roth IRA will be held in a separate account. And, legally, it is a bit different. The technical name for your child’s Roth IRA is a “custodial Roth IRA.” As Elliot Appel explains, “It’s similar to a normal Roth IRA, but since a minor can’t legally have their own account, a custodian, such as a [parent or] grandparent, manages the account until the child reaches age 18 or 21, depending on the state.” 

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The 4 Steps Involved in Opening a Roth IRA for a Child

Meg Bartelt helpfully details the 4 steps that she took to open a Roth IRA for her child:

1. She opened a custodial Roth IRA for her daughter. Since Meg’s daughter isn’t 18 yet, she can’t own her own investment accounts.
2. Meg contributed the money and selected an investment for the Roth IRA.
3. She matched her daughter’s Roth IRA contribution. The actual dollars that go into the Roth IRA don’t need to be the child’s money. As long as the child’s earned income, matches or exceeds the contribution amount, an adult may contribute their own funds to the Roth IRA.
4. Meg filed a tax return for her daughter. And on that tax return, Meg indicated that her child is a dependent of someone else (in this case, Meg!). The tax return helps to document the child’s earned income. And the dependent selection helps to match what you claim on your tax return (“my child is a dependent”) with what your child’s tax return states.

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When you open a Roth IRA for a child, you start an investing clock that can help put your son or daughter on the path to a stable, comfortable retirement. And perhaps just as importantly, you create an opportunity to teach your child about savings, investing, and how to manage money effectively through their life.

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The Millennial Finance Newsletter: April 30, 2024

For your days ahead: 3 perspectives, 2 articles, and 1 idea from me.

​Three Perspectives

1 / One of the most impactful financial moves you can make: how (and when) to open a Roth IRA for a child (editor’s note: see the article discussed above!)

2 / The most recent analysis on rent vs. buy (including a spreadsheet for your own circumstances!).

3 / What does financial flexibility actually mean?

​Two Articles

1 / Perhaps you’re familiar with index funds. But *which* index fund should you pick?

2 / Please read the fine print before you consider a bank’s “0% APR” line of credit.

One Idea From Me

I recently accompanied my youngest son on a field trip to the Air & Space Museum. As a daily bicycle rider, I was excited to find an exhibit about the Wright brothers’ experience owning a bicycle shop. I learned that they actually used their bicycle knowledge to inform their flight tests. Last week, I wrote about how we also can use what we know today to prepare for our future retirement:

1 / “Existing research shows that we should be able to withdraw about 4% of our investments annually in retirement. This data, while imperfect, indicates how much money we may need to save before we retire. But the exact amount depends on our spending.”

“Using the 4% guideline, we can know that we need to save 25x our annual spending to retire. “

You can read more in What To Know About Your Future Retirement.

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Your Questions About Opening a Roth IRA for a Child

I hope these articles help! Please feel free to send me an e-mail at kevin@illumintfc.com with any follow-up questions. You also can subscribe to my newsletter here to learn more about how you can turn your money into memories with your family. I typically send the newsletter twice each month.

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Recommended Money Reads for Millennials

If you liked this article, you may also want to check out:

• The Best 529 Plan for Virginia Residents
• The Best 529 Plan for Maryland Residents

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About Kevin Mahoney, CFP®

Hi, I’m Kevin. I’m the founder of Illumint and a financial advisor in Washington, DC. I specialize in financial planning for Millennials like you. As a Millennial father and Certified Financial Planner™, I empower our peers to invest with confidence and flexibility. If you’re new to Illumint, I’m glad you’re here – you now have access to free personal finance tips written specifically for Millennial parents. I encourage you to read, watch, or listen to the ideas I share about exchanging your money for memories with your kids. And then when you’re ready, please send me your thoughts & questions!