Updated April 2017 — Investing for retirement might seem like a far-off fantasy to young people when they're thinking only as far out as next week's game or test, but learning to save for the future can give kids a head start to do big things down the road. Opening a "kiddie" Roth individual retirement account (IRA) — a Roth IRA for a minor — is an easy way for younger people to prepare for their retirement or other large life events, such as going to college and buying a house, while at the same time learning the valuable lessons of financial responsibility and budgeting.
What is a "kiddie" Roth IRA?
At its core, the kiddie version of the investment account isn't any different from a regular Roth IRA, with the exception that the child's income, either from wages or self-employment, is the basis for the funding of the account. "Parents or grandparents can help the child by annually gifting the funds for the Roth contribution, as long as the amount gifted does not exceed the child's earned income," says Garrett Menaker, Senior Wealth Planner, Wells Fargo Private Bank. "In that way, the child could keep his or her earnings and still have the benefit of an early start at saving for retirement."
Opening a "kiddie" Roth IRA is an easy way for younger people to prepare for their retirement or other large life events, while at the same time learning the valuable lessons of financial responsibility and budgeting.
For 2017, a child can contribute up to $5,500 but no more than the amount of his or her taxable income. The maximum contribution is based on the child's modified adjusted gross income (a number found by taking the adjusted gross income and adding back deductions such as interest on student loans and college tuition and fees). If that figure is $118,000 or less, the child can contribute up to the maximum $5,500. If, however, the child's modified adjusted gross income is greater than $118,000 but less than $133,000, the maximum contribution allowed will be reduced, and no contribution will be allowed if his or her modified adjusted gross income is equal to or exceeds $133,000.
The rules for taking distributions
After a Roth IRA has been open for five years and the account owner is at least age 59 1/2, he or she can take out any funds without any income tax or penalties. A Roth IRA for a minor is no different. "If funds are needed before age 59 1/2, they may be withdrawn without penalty as long as the funds are used for specific exceptions like qualified higher education expenses, a first home purchase, and medical expenses," says Menaker. Tuition, fees, books, supplies, equipment, and even room and board for an eligible college or vocational school can all be considered legitimate educational expenses.
People use their Roth funds for various purposes, but many set up the account with longer-term goals in mind, such as buying a house — up to $10,000 may be withdrawn without penalty for a qualified first-time home purchase — or retirement, because there's no requirement to withdraw money by a certain age. Ideally, you'll want to leave your money in the account for as long as possible. "The balance may grow pretty significantly because of the tax advantages that it has — funded with earned income that is typically taxed at a low rate for minors, the account can potentially grow tax-free, and withdrawals can be tax-free if certain conditions are met," says Menaker.
The overarching potential advantages of opening a Roth
Aside from the obvious benefit of being a great investment tool for kids, managing a kiddie Roth account opens up the opportunity for children to participate in family conversations about money, learn lessons about how to budget, and appreciate the long-term value that their hard-earned dollars can bring, "I would encourage my own child to open up a Roth IRA," Menaker says. "I really like the idea of the child being able to discipline himself or herself about money — it is a good way to help a child understand the opportunity cost of giving up the right to spend his or her money now for the chance to have it grow into something much bigger."