How a custodial IRA can help your child with future retirement savings

A friend recently recounted to me that as a teenager she cashed the checks from her first job and kept half of the earnings while giving the other half to her mother for her “savings account,” which was the bottom of a dresser drawer. I tried not to show my disappointment, as she could have greatly benefited from the power of compound growth by investing that money into a Roth individual retirement account (IRA).

When it comes to saving for retirement, there’s a common saying: The earlier you start, the better—and the earliest your children can start is with a custodial IRA.

A custodial Roth IRA can be a great way to instill the value of investing for a child with earned income. This income could be from a job that provides a Form W-2 or a side gig, such as dog walking or babysitting.* The custodial Roth IRA is managed by a parent or legal guardian on behalf of the child. The contribution limit for a Roth IRA in 2024 is the lesser of $7,000 or your child’s total compensation for the year. Once your child has earned income, it doesn’t matter who contributes to the IRA. You may be able to entice your child to open an account by offering to make matching contributions from you or by funding the account up to the allowable amount. That way they will still have money left from their paycheck to spend however they choose.

Once the custodial 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 its flexibility. Contributions are available anytime, and withdrawals of earnings can be made penalty-free in some circumstances prior to age 59½.** But as the IRA custodian, it is important to make clear to your child that it would be most advantageous to hold on to the account for the use of funding their retirement. Also, be sure to discuss the adoption of a custodial Roth IRA with your financial advisor to make sure it fits with your existing financial plan and goals.

The value of 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 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.

If you manage a custodial IRA for your child, they will assume complete control over the account when they turn 18 (or 21 in some states) once they've completed the necessary paperwork. This means they are free to continue contributing, or they can liquidate the account to pay for their first home, college tuition, or any other expense.

The sooner your children can start saving for retirement, the better off they’ll be in the long run. It doesn’t only matter when you start saving; it matters where you start saving. 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.