Starting a Roth IRA for a Child or Grandchild

By Dave Rao
Tuesday, October 30, 2018

This early financial decision could prove profoundly positive over time.

Do you have a child or grandchild earning some income? Indirectly, that after-school or summer job might present a savings opportunity for a teenager. You could help your child or grandchild save for future goals by assisting them in creating and funding a Roth IRA.

So many people wish they had begun saving for retirement sooner. Imagine how a teenager’s prospects for building lifetime retirement savings might improve by starting as soon as possible.

Here is a little math to illustrate the potential. Suppose $1,000 is deposited into a Roth IRA when a child is age 17 and $100 per month goes into the account thereafter. Suppose the IRA compounds annually and returns 7 percent a year. After 45 years of saving and investing just $100 a month with a $1,000 lump sum to start, that IRA contains $363,902 by the time the person is age 62. From very little investment effort, a considerable sum might arise over time — and 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 yearly 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 2018 is $5,500. You can give the child the money to contribute, if you prefer.

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. Income earned as an independent contractor is also acceptable. 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.


Dave Rao

The potential tax advantages of a Roth IRA are profound. Earnings in a Roth IRA grow tax free, and they may be withdrawn without being taxed once the IRA owner is age 59 and has owned the IRA for five years. If your teen invests steadily and minds Internal Revenue Service (IRS) rules, he or she could retire with a tax-free retirement fund that might be six or seven figures. Even a 25-year-old who contributes $5,000 a year to a Roth IRA earning 8 percent for 40 years is positioned to have about $1.4 million at age 65. Once the owner reaches the allowable age and IRS rules are followed, funds can be withdrawn, tax free.

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 that child’s life, the Roth IRA assets may be useful in multiple ways. Did you know up to 100 percent of Roth IRA contributions may be withdrawn by a Roth IRA owner at any age, without any tax penalty? While reducing a retirement account balance is never ideal because it hurts compounding, this option does offer a young IRA owner a potential financial resource in an emergency. Earnings withdrawn prematurely will usually be taxed, and likely also hit with a 10 percent IRS penalty, but there is a notable exception. Did you know up to $10,000 of earnings can be taken out of a Roth IRA, tax free, at any time if the money is used to buy a first home? The IRS even waives its 10 percent early withdrawal penalty in that case. If your child or grandchild becomes a parent, some of those Roth IRA assets might later be used to pay college tuition.

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 today.


Dave Rao is the founder of RAO Wealth Partners. He focuses his practice on helping to advise physicians, corporate executives and business owners on their unique financial situations. For more information, visit raowp.com.

Our firm does not render legal or tax advice. This article was written for our firm and provided courtesy of MarketingPro. Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE. Rao Wealth Partners is an independent firm with securities offered through Summit Brokerage Services Inc., member FINRA and SIPC. Advisory services are offered through Summit Financial Group, Inc., a registered investment adviser. Summit is an independent broker-dealer with client assets held at First Clearing LLC (a wholly owned Wells Fargo subsidiary). Summit and its affiliates are under separate ownership from any other named entity.