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: A Roth IRA carries the potential for tax-free income, which could make a Roth the gift of a lifetime for a child, teenager, or an adult child. 

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

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

Young adults, who are deemed minors, can’t manage the account. Instead, they’ll need to use a custodial IRA. Although the IRA remains the property of the minor, it will need to have a custodian, such as a parent, oversee the account until the child reaches age of majority (generally age 18 for most states). Upon reaching the age of majority, the account is switched to a “regular” Roth IRA, when the young adult will then oversee the account where he/she can transactions (on the account) without parental consent.

No minimum age – There is no minimum age to establish and contribute to a Roth IRA. Instead, all that’s required is compensation (earned income) that cannot exceed an annual threshold. For details on what is (and isn’t) compensation – see IRS Publication 590-A “Contributions to Individual Retirement Arrangements (IRAs)"

Earned income – If a child has reportable compensation (earned income), he or she can contribute to their 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 babysitting or dog walking. Gifts do not count as compensation. 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.”

Consider hiring your children if you are a small business owner; this will create earned income, which can then be used to fund a Roth IRA. Importantly, 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 one’s 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 annual Roth IRA contribution limit is $7,000 for 2024, or the total (child’s) earned income for the year, whichever is less. Also, it is possible to fund a child’s Roth IRA for the prior tax year until April 15th of the current year.

EXAMPLE:

Jill, 16, earned $3,000 as a lifeguard. Jill’s parents or another family member can set up and contribute to a Roth IRA (up to a maximum of $3,000, the amount Jill earned) on her behalf.

Establishing a retirement account won’t prevent Jill from spending her hard-earned paycheck while her parents or other family member fund a Roth IRA on her behalf.

Tax-free earnings and distributions – This is the best part of establishing a Roth at any age: Roth assets grow tax-deferred, potentially for decades, and the income, including earnings, can be distributed tax-free at a later date. A tax-free distribution from a Roth IRA is available upon the account owner attaining age 59 ½ and holding the account for five years.

Roth IRA distributions – Roth IRA contributions (basis) can be distributed both tax- and penalty-free at any time or age, regardless of whether the “five-year” holding period has been met. Let’s say, John, age 24, has a $20,000 in his Roth IRA of which $15,000 consists of contributions (basis). He can withdraw the full $15,000 tax- and penalty-free.

While Roth IRA contributions can be distributed at any age, time, or for any reason without being assessed tax or penalty; those distributions made prior to age 59½ that include earnings will generally be subject to income tax and a 10% penalty tax unless an exception applies.

Higher education – There are other ways a teenager or young adult can use Roth funds. For example, 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, should the earnings be distributed, although taxable, an exception applies to the 10% early distribution penalty tax for such expenses.

Retirement accounts are generally 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, 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 tax, 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 tax.

Talk about saving early–and often

When it comes to retirement savings, 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) should consider having recurring conversations about saving and investing 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.
  • Roth IRAs are flexible: The funds can be used for more than retirement, such as college or purchasing a home.

Questions? Please contact your Lord Abbett representative at 888-522-2388.