With Thanksgiving in the rearview mirror, retailers are busy with customers breezing through for holiday specials, searching for the perfect gifts for their loved ones. Some prioritize material gifts, such as clothing or camping gear, while others focus on experiences, like travel or concert tickets. Monetary gifts are also popular. If you favor giving money or gift cards to the children or grandchildren in your life, consider a different kind of monetary gift this year: a custodial Roth IRA.

What is a Custodial IRA?

A custodial IRA is a tax-advantaged retirement account controlled by an adult, with ownership belonging to the child, and must be converted to a regular Roth IRA when the child reaches the age of majority. Contributions are made with after-tax dollars, grow tax-free, and these contributions (not earnings) can be withdrawn without penalty at any time, provided the account has been open at least five years. While a child of any age can have a custodial IRA, the child must have earned taxable wages to qualify. Case in point: a 15-year-old who worked at a golf course as a mower over the summer and receives a W-2 showing earnings is most likely eligible for a Roth IRA. The contribution limit is the same as for adults: $6,500 in 2023 ($7,000 in 2024). The child can contribute up to the annual limit or up to the full amount of their annual earnings, whichever is less. For example, if that 15-year-old who mowed lawns made $5,000 over the summer, he or she may contribute the full $5,000 to the Roth IRA. While the child may be quite capable, the law requires an adult to help them open the account. Many of these accounts can be set up online. However, you’ll need to provide the child’s Social Security number, date of birth, and other pertinent personal information.

Why Gift a Custodial IRA?

Now that we’ve briefly covered the dynamics of a custodial Roth IRA, you may be wondering what makes this a great gift idea. First, younger investors have a significant advantage over older adults in that they have more time for their accounts to grow. If that 15-year-old has a 50-year timeframe until retirement, that’s five decades of tax-free investment growth. That $5,000 contribution, generating a 7% investment return, compounded monthly, would be worth approximately $164,000 in 50 years, assuming no added contributions or withdrawals. While no one can predict what will happen with savings account interest rates or bond returns, historically, investing in a diversified portfolio of equities over a lengthy period may generate significantly greater return versus investments with a fixed rate of return. Furthermore, contributions can be withdrawn at any time completely tax-free and without penalty, provided the account has been open at least five years. This differs from many retirement accounts that incur a 10% penalty for withdrawals prior to age 59 ½, and having to claim the funds as income. The caveat, however, is that while contributions are tax-free, if the child taps into the account’s earnings before retirement, taxes and penalties may apply.

Custodial Roth IRAs can be a great educational tool for children, enabling them to plan for a major financial goal like retirement while learning about the long-term value of compound earnings. If the child needs to access the funds before retirement, the rules for these accounts offer some tax-free and penalty-free ways to do it. For example, the child could take out up to $10,000 in earnings for a first home (assuming the account has been open for five years), or pay for qualifying educational expenses such as college tuition (earnings may be subject to income tax, but there would be no early distribution penalty), or pay for qualified medical expenses that don’t exceed 10% of their adjusted gross income.

Lastly, at the time of this writing, retirement accounts aren’t reported as assets on the Free Application for Federal Student Aid (FAFSA), so a Roth IRA won’t impact their financial aid.

We believe financial planning is a year-round activity that affects almost everyone. We also believe it’s important to educate younger generations and guide them in pursuit of their financial goals. If you have or know a child who has worked hard over the past year and are interested in incorporating the child’s income into your household’s financial plan, reach out to us here at Savant. Happy holidays!

This is intended for informational purposes only and should not be construed as personalized investment or financial advice. Please consult your investment and financial professional(s) regarding your unique situation.

Author Jonathon D. Merickel Portfolio Advisor

Jonathon has been involved in the financial services industry since 2002. He earned a bachelor of science degree from Syracuse University and an MBA from Le Moyne College.

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