Reasons to Consider a Roth IRA for Kids | Lord Abbett
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Retirement Perspectives

Kid’s don’t think about their retirement. Luckily you can. A Roth IRA can help jump start a child’s nest egg.

A Roth IRA may not be included on a child’s wish list, but parents and grandparents might want to write it in. And for good reason. Roth IRA carries the potential for tax-free income, which could make a Roth the gift a lifetime for a child, teenager, or an adult child. 

 

Not only is a Roth IRA a great way to potentially build tax-free wealth for the next generation, it can help you start a key conversation with your child about the value of saving for the future.

 

Many parents and advisors may not have considered establishing a child Roth IRA. Not all IRA providers allow them (or are aware) that minors can set up an IRA, so you should check with your custodian. (TIPLord Abbett allows minors to establish an IRA.) Also, financial institutions typically do not permit minor children to open a Roth IRA on their own. That is where you come in.

Many IRA custodians allow parents to serve as guardian on a Roth IRA for the benefit of their children. However, when the minor attains the age of majority, typically 18, ownership of the Roth IRA would revert to the child (as an adult). The child then can make transactions on the account without parental consent.

Quick Facts

Who can set it up – A generous relative (or anyone, for that matter) can set up a Roth IRA and fund the account. In other words, a child doesn’t have to use their own hard-earned income to fund a Roth IRA, but they can if they want to. 

No minimum age – There is no minimum age be eligible to establish and contribute to Roth IRA. Instead, all that’s required is reportable earned income (i.e. W-2 or self-employment income), and the income cannot exceed an annual threshold.

Earned income – If a child has reportable earned income, he or she can contribute to a Roth IRA. Earned income is defined by the IRS as taxable income and wages — money earned from a W-2 job, or from self-employment gigs such as baby-sitting or dog walking. Notably, the IRS only requires gross income to qualify for an IRA contribution – not net income. For details on child tax reporting and liability, see IRS publication 929 Tax Rules for Children and Dependents.

PRACTICE TIP: Consider hiring your children if you own a business, which will create earned income which can be used to fund a Roth IRA. Important: You must pay your child reasonable compensation -- what would be considered “fair” compensation for the same job in the marketplace. Also, there is no requirement to withhold payroll taxes (Social Security, Medicare, FUTA, etc.) when paying ones’ own children – so long as the child is under age 18 and the business is a sole proprietorship or a partnership (each partner is a parent of the child). This benefit is not available to corporations. It’s wise to talk to an accounting professional before hiring your child as an employee.

Contributions and contribution limits – The Roth IRA annual contribution limit is $6,000 in 2021, or the total of earned income for the year, whichever is less. If you want to contribute to your child’s Roth IRA or match your child’s contributions, he or she must have as much earned income as the total contribution amount.

EXAMPLE

Let’s say Jill, 15, made $2,500 as a lifeguard last summer. Jill’s parents can set up and contribute to a Roth IRA (up to a maximum of $2,500, the amount Jill earned) on her behalf. Establishing a Roth IRA won’t keep Jill from spending her hard-earned paycheck while her parents fund a Roth account on her behalf.

Tax free earnings and distributions – This is the best part: Roth assets will grow tax-deferred potentially for decades, and the income, including earnings, can potentially be withdrawn tax-free at retirement.

Roth IRA distributions – Roth IRA contributions (basis) can be distributed tax and penalty-free at any time or age, regardless of whether the “five-year” holding period has been met.

Whether your Roth IRA withdrawal is subject to tax and or 10% early distribution penalty depends on a few factors. While Roth IRA contributions can be distributed any age or time and for any reason without assessed tax or penalty, if the distribution is made before age 59½ and includes earnings, then you may have to pay both income tax and a 10% penalty unless an exception applies.

Higher Education – There are other ways a teenager or young adult can use Roth funds. A young adult can take a tax- and penalty-free distribution of Roth IRA contributions (basis) to help offset expenses related to higher education. Moreover, an exception applies to the 10% early distribution penalty for such expenses.

TIP: Retirement accounts are not considered assets on the Free Application for Federal Student Aid (FAFSA) form, so the value of your Roth IRA won’t lessen your chances for qualifying for financial aid. However, when taking a Roth IRA distribution to pay for college, it may be counted as untaxed income on the FAFSA.

Saving for college or a house Roth IRA funds could also help to pay for a first home. Plus, if you’re an eligible first-time homebuyer, you can withdraw up to $10,000 in earnings from your Roth IRA without the 10% early-withdrawal penalty, even if you’re under 59½. You’ll also avoid a tax bill on that withdrawal if you’ve had a Roth IRA for at least a five-year period. If you don’t meet the five-year test, you will be subject to taxes on $10,000, but not the 10% penalty.

Talk About Saving Early and Often

When it comes to money, a lot depends on a child’s maturity, financial literacy, and commitment to saving and investing for their future. With that in mind, parents (and other adult benefactors) might want to have recurring conversations about thrift when the kids are younger to be reasonably comfortable that the child will honor the intent of the Roth.

Key Takeaways

  • The potential tax advantages of a Roth IRA are hard to ignore. Add in years of compounding, and the sooner you set up an account, the better.
  • Contributions can only be made if the child has earned income.
  • Flexibility: The money can be used for more than retirement, such as college or purchasing a home.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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