They say it’s never too early to start saving for retirement, right? Well, that’s certainly the theory behind the custodial Roth IRA.
Using a retirement-focused investment vehicle like a custodial Roth IRA, an adult can set up an account to invest in a child’s financial future. There are a few major advantages that come from using a custodial Roth IRA — but there are also some disadvantages you may want to think about.
This guide explains what a custodial Roth IRA is, the difference between a Roth IRA and a traditional IRA, and how a custodial Roth IRA is different from a UGMA custodial account.
What is a Custodial IRA?
A Custodial Individual Retirement Account (IRA) is an investment vehicle that an adult can use to save for the financial future of a minor.
With a custodial IRA, an adult can set up a retirement account on behalf of a minor beneficiary. Because the child is too young to manage the assets in the custodial IRA, the adult serves as the account’s custodian.
As its custodian, the adult is responsible for making investment decisions in relation to the account — but it’s important to bear in mind that every dollar invested in a custodial IRA is the legal property of the child.
When the minor beneficiary reaches the age of majority in their state, the custodianship ends.
That means all of the assets will move into a normal IRA, which the (now grown-up) child becomes responsible for managing it themselves.
The age of majority is slightly different in every state — but in most states, it’s either 18 or 21.
When you hear people talking about custodial IRAs, they’ll be referencing one of two different account types: the custodial Roth IRA and the traditional IRA.
The key difference between the two is how your contributions are taxed. But we’ll break that down in detail in just a minute.
The key element of a custodial IRA that you should remember is that an adult can only set up a custodial IRA for a child if the child has earned income.
That means you can set up a custodial IRA for your teenager if they work part-time at a grocery store or are making regular income babysitting. But if the minor you want to save for isn’t bringing any cash in, you’re going to have to find an alternative investment vehicle to use.
What’s the Difference Between a Custodial Roth IRA and a Traditional IRA?
Both custodial Roth IRAs and custodial traditional IRAs are designed with the same goal in mind: to help a child save their income for the future (ideally, for retirement).
But there’s a key difference between the two account types in terms of how they function from a taxation point of view.
When you set up a traditional custodial IRA for a kid in your life, it’s important to know that the account holder is taxed on any income the account generates when that money is withdrawn.
Those funds are taxed by the Internal Revenue Service (IRS) at whatever the applicable tax rate is when the minor beneficiary retires.
Translation: all of the funds in a traditional custodial IRA are considered pre-tax. This applies to both the contributions you’ve made on behalf of a child and any earnings the account may have accrued through compound interest.
As a result, the major benefit of a traditional IRA in the here and now is that you don’t have to worry about taxes.
But if you fast-forward a few decades, the child you’ve been saving for will then be responsible for paying taxes on account withdrawals — placing an extra tax liability on them.
The Roth IRA works pretty much the same way. But unlike a traditional IRA, with a custodial Roth IRA account, you’ll pay taxes when you put money into the account.
All of the contributions you’ve made to a custodial Roth IRA — as well as any earnings that account has accumulated over time — are considered after-tax money by the IRS.
That means the major benefit of setting up a custodial Roth IRA for a child in your life is that you’re not handing them a tax liability for the future.
With a child's Roth IRA, the beneficiary won’t be responsible for paying income tax on any of the withdrawals they make in future decades. That will make life a whole lot simpler for them — which is why the custodial Roth IRA is usually a more popular choice.
What are the Rules for Custodial Roth IRAs?
We’ve covered why custodial Roth IRAs are generally the preferable choice over traditional custodial IRAs. Now, let’s break down the rules for custodial Roth IRAs.
Some of these rules are really helpful. Others may understandably make you want to reconsider setting up a Roth IRA for a child you love.
First, the IRS doesn’t impose any sort of minimum age limit for contributing to a Roth IRA.
You’re allowed to set up an account for a child of any age — as long as they’re currently under the age of majority in their state.
Next, the child you’re setting up a custodial Roth IRA for must have some sort of earned income.
What exactly constitutes “earned income”?
According to the IRS, earned income is any sort of taxable income or wages. That means money a child has earned from W-2 employment. But it also means any sort of work that’s considered self-employment.
By self-employment, we’re talking about babysitting, dog walking, mowing lawns, or other regular odd jobs.
To help boost a child’s earnings, you, as the adult custodian, are allowed to contribute to that beneficiary’s Roth IRA. But there’s a caveat here: you can only contribute as much as the child’s earned income.
For example, if the child you’re saving for earns $5,000 per year mowing lawns, that means you could match their contribution by placing $5,000 worth of your own money in the account.
But while we’re talking dollar amounts, it’s also critical to know that a Roth IRA has contribution limits. Unfortunately, those contribution limits are fairly low, too.
In the 2021 tax year, the IRS imposed a Roth IRA contribution limit of $6,000 per year. That same contribution limit applies to custodial Roth IRAs, too.
Note: If you’re aged 50 or older, you’re allowed to contribute slightly higher to a Roth IRA. The contribution limit for over-50s is $7,000 per year. But this doesn’t really come into play when talking about a custodial Roth IRA, as the account owner (the child) must be well under 50.
But there is one more consideration in terms of contribution limits you should remember.
While the limit is $6,000 per year for under-50s and $7,000 for over-50s, it can actually be even lower if the child beneficiary earns less than the contribution limit.
For example, let’s go back to that lawn mowing example from earlier.
If the child you’re saving for only earns $5,000 per year, then that’s the account’s contribution limit for that tax year. Even though the potential max amount you can contribute to a Roth IRA is $6,000, you’ll only be able to contribute $5,000 to the account.
Finally, you need to consider withdrawal rules that apply to both the beneficiary and the account’s custodian.
When you save using a custodial Roth IRA, the child whose financial future you’re helping save for will inherit a decent amount of flexibility when compared to other types of retirement accounts.
For example, with a Roth IRA, the cash contributions you make to the account can be withdrawn at any time. That flexibility is allowed because there are pretty strict rules for Roth IRAs where account earnings are concerned.
All distributions of account investment earnings end up getting taxed as income. They could also be subject to a 10% early distribution tax penalty.
But because of the custodial Roth IRA’s low contribution limits and these rules on account earnings, a lot of adults tend to look for alternatives to the Roth IRA — and one of the most popular alternatives is a UGMA custodial account.
How are Custodial Roth IRAs Different From UGMA Custodial Accounts?
When it comes to saving for a child’s financial future, adults have quite a few options. Two of the leading account types for this purpose are the custodial Roth IRA and the UGMA custodial account.
But there are a couple of key differences between the two account types that you should think hard about.
In principle, custodial Roth IRAs and UGMA custodial accounts are a lot alike.
First, let’s talk a little bit about custodial accounts.
The UGMA custodial account is named after the legislation that created it: the Uniform Gifts to Minors Act (UGMA). It’s one of two types of custodial accounts, alongside Uniform Transfers to Minors Act (UTMA) accounts.
But because not all 50 states have ratified the UTMA, you can’t set one up in every single US state.
The UTMA is also designed to hold a wider range of assets that don’t apply to most families — like fine art or intellectual property. Meanwhile, UGMA accounts are designed for more common asset classes like stocks, bonds, exchange-traded funds (ETFs), and mutual fund shares.
For those reasons, most families opt for a UGMA instead of a UTMA account. That’s why we’re going to focus on UGMAs and how they’re different from Roth IRAs.
Both the custodial Roth IRA and UGMA account are designed to help adults build a nest egg for the young people in their lives.
Likewise, with both account types, the adult who opens the account serves as its custodian. This means they’re responsible for managing all of the account assets on behalf of a child beneficiary until they reach a certain age.
When that minor beneficiary reaches the age of majority in their state, the custodianship gets terminated, and management of the assets passes on to the now-adult beneficiary.
But unlike a custodial Roth IRA, UGMAs don’t have contribution limits. That means you can contribute as much money to a child’s UGMA as you’d like to — although you will need to bear in mind the gift tax.
Likewise, you can place as much of a child’s earned income into a UGMA custodial account on their behalf without having to worry about contribution limits.
UGMA accounts also come with a pretty solid tax benefit. The dividends and capital gains a custodial account produces are taxed at the child’s much lower tax rate, rather than the adult’s tax rate (up to a certain point).
This is called the “kiddie tax.” In 2021, the IRS kiddie tax threshold was $2,200. For some families, this can represent large savings in terms of tax liability.
The final difference between Roth IRAs and UGMAs is what happens when the child reaches the age of majority.
With a custodial Roth IRA, all of the child’s assets will typically be moved into an ordinary Roth IRA — the child beneficiary will simply become the account holder. Although withdrawals can be made, the assets in their account will still be part of a retirement account designed to save for the child’s future retirement.
With a UGMA account, the child beneficiary will be able to access and use all the funds as soon as they reach the age of majority. They can choose to move those assets into an IRA, put them into another investment account, or spend the cash right away. It’s totally up to them.
We all want to set up the kids we love for success, and one of the best ways to achieve that is by helping them build up a nest egg for the future.
Fortunately, you have numerous good options when it comes to investment vehicles you can use to save for a child — and two of the most popular options are custodial Roth IRAs and UGMA custodial accounts.
Both account types can be a great way to build up wealth over time. But because UGMA accounts don’t have income requirements or contribution limits, UGMAs are generally the better option for a lot of families.
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