retirement savings  |  june 3, 2022

How a Custodial IRA Can Give Your Child a Head Start on Retirement Savings

Give your child a leg up on their future by opening a Roth IRA for them as soon as they start earning income.


Key Insights

  • An adult can open a Roth IRA for minors with earned income (without any age requirement) and can contribute the amount of money the child earned for that
    year, up to the IRA contribution limit ($6,000 for 2022).

  • Opening a Roth IRA for a child allows for many decades of compounded growth, enabling the account to grow substantially until retirement.

  • Once the IRA is open, all assets are managed by a parent/guardian until the child reaches age 18 (or 21 in some states).

  • Roth IRAs can also be used for college expenses or for the purchase of a first home.

Judith Ward, CFP®

Thought Leadership Director

We all know that it’s a smart idea to start teaching your child the value of money early on. “A friend recounted to me that as a teenager, she recalled cashing the checks from her first job, keeping half and giving the other half to her mother for her “savings account,” which she kept in her dresser drawer,” says Judith Ward, CFP®, a thought leadership director with T. Rowe Price. “Little did either of them know at the time that they could have greatly benefited from the power of compound growth by investing that money in a Roth IRA.” When it comes to saving for retirement, there’s a common saying: The earlier you start, the better. And the earliest you can start is with a custodial IRA.

The Benefit of a Roth IRA

A Roth individual retirement account (IRA) may be a great way to instill the value of investing for a child with earned income. This income could be from a dog walking or babysitting job or from a job that provides a Form W-2.* The account is managed by a parent, or another adult such as a grandparent or uncle, on behalf of the child. The contribution limit for a Roth IRA in 2022 is the lesser of $6,000 or your child’s total compensation for the year. Once your child has earned income, it doesn’t matter where the IRA contributions come from. You may be able to entice your child to open an account by offering matching contributions from you or a grandparent or by funding the account up to the allowable amount. That way they will still have money left from their paycheck to go shopping or out with friends.

Once the Roth IRA is open for a minor, all assets are managed by the custodian until the child reaches age 18 (or 21 in some states). Given the tax bracket most teens are in, and the length of time they have to invest, a Roth IRA may provide the most long-term financial gain. An additional benefit of a Roth IRA is the flexibility it provides. Contributions are available anytime. And withdrawals of earnings can be made penalty-free in some circumstances prior to age 59½.** But it is important to make clear to your child that it would be most advantageous to hold onto the account for the use of funding their retirement.

The Potential Growth of a Roth IRA

Through the use of a custodial IRA, modest contributions starting at age 15 through retirement could build quite a substantial nest egg in this account alone. For example, a 15-year-old contributing $3,000 every year through retirement has the potential to accumulate $1,219,587 by age 65.

A 15-year-old contributing $3,000 every year through retirement has the potential to accumulate $1,219,587 by age 65.

Assumptions: Hypothetical example beginning at age 15 assumes an annual contribution of $3,000 and a 7% annual investment return. Total balances accumulating over 10, 20, 30, 40, and 50 years, respectively. This example is for illustrative purposes only and is not meant to represent the performance of any specific investment option. The assumptions used may not reflect actual market conditions or your specific circumstances.

What About Financial Aid?

If you are concerned that a Roth IRA could affect your teen’s financial aid eligibility for college, know that Roth IRAs are not currently a factor in the federal financial aid formula. While universities offering nonfederal financial aid can apply their own requirements regarding Roth IRAs, only some private universities consider these assets in relation to tuition assistance. However, if withdrawals from the Roth IRA are used to pay for college, that income amount will be considered in a future year’s eligibility process and could have an impact.

The Pros and Cons of Custodial IRAs

Here’s an overview of the advantages and disadvantages of custodial IRAs.

Pros of a Custodial IRA

  • Your child can take advantage of the power of compounding over several decades, which could allow the account to grow substantially.

  • A child’s earnings may be so low that they are not taxable.

  • There are no early withdrawal penalties on contributions to a custodial Roth IRA. Your child can withdraw money for college, to open a business, or for other expenses.

  • Your child can withdraw up to $10,000 worth of earnings from the IRA,
    without a penalty, for the purchase of their first home.

Cons of a Custodial IRA

  • There are contribution limitations for IRAs–currently up to $6,000 a year.

  • Custodial Roth IRAs are not tax-deductible.

  • At age 18 or 21, account control will transfer to the child, so it is important that they understand the value of leaving their investments as is and letting the money continue to grow.

  • Your child will not be assessed a penalty on contributions withdrawn but may have to pay a penalty on the earnings, such as interest and dividends, if the withdrawals do not fall under qualified distributions.***

***A qualified distribution is tax-free if taken at least 5 years after the year of your first Roth contribution and you’ve reached age 59½, become totally disabled, died, or met the requirements for a first-time home purchase.

All Savings Accounts are Not Created Equal

“The various methods of saving for your child’s future, and teaching your children about the value of money, are not created equal,” says Ward. “The sooner you can start saving for retirement, the better off you’ll be in the long run.” But it doesn’t only matter when you start saving, it matters where you start saving, too. A Roth IRA has much higher earning potential than a regular savings account. Give your child a leg up on their future and help them learn the immense value of compounding and importance of investing for the long term by opening a Roth IRA for them when they start earning income.

*Note that the child’s income may need to be declared as taxable self-employment income in the year it is earned. We suggest consulting with a tax professional.
**Withdrawals of earnings from Roth IRAs can be made penalty-free if the account has been open for five years or more and the money is used for exceptions such as qualified higher education expenses, a first-time home payment up to a lifetime limit of $10,000, certain unreimbursed medical expenses, and other situations.

Important Information

An IRA should be considered a long-term investment. IRAs generally have expenses and account fees, which may impact the value of the account. Non-qualified withdrawals may be subject to taxes and penalties. Maximum contributions are subject to eligibility requirements. For more detailed information about taxes, consult IRS Publication 590 or a tax professional regarding personal circumstances.

This material is provided for general and educational purposes only and is not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not intended to suggest that any particular investment action is appropriate for you. Please consider your own circumstances before making an investment decision. T. Rowe Price group of companies, including T. Rowe Price Associates, Inc., and/or its affiliates, receive revenue from T. Rowe Price investment products and services.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation, or a solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The views contained herein are those of the authors as of April 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. Investors cannot invest directly in an index.

All investments involve risk. All charts and tables are shown for illustrative purposes only.

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