Giving the Gift of a Roth IRA

Thomas Stedman, CFP®
Wealth Management Consultant

Nov. 30, 2023

Key Takeaways

  1. Give your child or grandchild head starts on their retirement savings by opening a custodial Roth IRA (Individual Retirement Account).
  2. Know the basics of making IRA contributions and what qualifies as earned incomes.
  3. Understand some of the benefits and potential drawbacks of how custodial Roth IRAs work.

With another holiday season upon us, many of us are questioning what to get our loved ones, especially children or grandchildren whose interests seem to change like the weather. While stores across the country are sold-out of the latest must-have gadget, an even better gift may be helping them kickstart their retirement savings with a Roth IRA.

Younger generations are having a tough time saving for retirement, often graduating from college saddled with significant debt and facing underwhelming wages. However, the good news is that starting a retirement savings plan now combined with the power of compounding and time can have a profound impact on someone’s ultimate retirement balance.

Take this for example: if you invested $6,000 a year and earned a 7% return from age 14 all the way until age 70, it would grow to $3,968,704. If instead you delayed 20 years to begin saving, until age 34, you would only have $962,024 at age 70, about a $3,000,000 difference!

Roth IRA Basics 

Roth IRA contributions are considered “after-tax” and future withdrawals come out tax-free. Therefore, they usually make more sense for those in lower tax brackets, like children, and allows them to take full advantage of decades of tax-free growth.

For tax year 2023, the contribution limit for all IRAs is either…

  • $6,500 (for those over 50, it is $7,500)
  • Or equal to a person’s total income

For example, if your child or grandchild only makes $2,000 babysitting throughout the year, they cannot contribute more than $2,000 to a Roth IRA.

The deadline to make contributions corresponds with the tax filing deadline for individuals (not including extensions), which will be April 15th in 2024.

Eligible Income & Considerations

Annual Roth IRA contributions can be made as long as there is earned income. This can include employment income reported on a W2 or self-employment income, like income from babysitting or mowing lawns.

If your child or grandchild doesn’t file a tax return because their income is lower than the standard deduction, it is important to keep a detailed log of earnings and ensure their business is set up legally. They may also be on the hook for Medicare and Social Security taxes so it may make sense to talk to your tax advisor before matching the earned income from their “side hustle” with a Roth IRA contribution.

Other Factors

A custodial Roth IRA for a child or grandchild becomes their own when they reach the legal age of majority in their state (18 or 21). This means they have full access to the assets and can make a withdrawal if they choose. However, taking a withdrawal before 59 ½ will likely involve a penalty and taxes so hopefully, at this point, they understand how important it is to let it grow until their retirement years. Furthermore, while having a retirement asset like a Roth IRA isn’t recognized on most financial aid forms like FAFSA, withdrawals from an account are considered income to the student so can impact how much aid they receive during their college years.

While the primary goal of a Roth IRA is saving for retirement, they can also be used towards qualified higher education expenses and $10,000 towards a first-time home purchase, without incurring the early withdrawal 10% penalty and taxes. You can think of it as a second 529 plan in helping them pay for higher education but without the worry of it not being fully depleted if they don’t go.

For those looking to utilize the recently increased annual exclusion gift amount of $17,000 per person ($18,000 in 2024) and reduce assets in their estate, this may be the perfect opportunity to significantly benefit your heirs and reduce potential estate taxes. It is one gift that truly keeps on giving.

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The information in this paper is not intended as legal or tax advice. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation.

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