Custodial IRA: How to Open a Retirement Account for Kids
Brokerages and financial institutions generally require you to be an adult to open an investment account.
Typically, that means a child cannot open a brokerage account independently in their own name.
This can be discouraging when you’re trying to teach your child the benefits of investing early in life.
Thankfully, your child can invest with the help of an adult.
Instead of opening their own account, you can open a custodial account on their behalf.
If your child wants to start setting money aside for retirement to take advantage of compounding returns, you may want to look into a custodial IRA.
Here’s what you need to know.
What Is a Custodial IRA?
A custodial IRA, commonly referred to as an individual retirement account, allows an adult to open and manage an IRA on behalf of a minor.
Custodial IRAs can be opened as traditional IRAs or a custodial Roth IRA, depending on your situation and choices.
How to Open a Custodial IRA
If you’re ready to open an account for your child, here’s what you should know.
Opening a custodial IRA is a bit more work than a regular IRA.
You’ll need to provide information about your child.
This includes their birth date, Social Security number, and other identifying information.
You’ll likely need to provide this information about the custodian, too.
Depending on the financial institution, you may be able to open a custodial IRA online. Others may require you to call a phone number, apply in person, or mail in a paper application.
Contact the institution you’re considering to see how their application process works and what information you’ll need.
Picking Where to Open an Account
Deciding where to open a custodial IRA is very important.
While most financial institutions offer IRAs for adults, fewer offer custodial IRAs.
You’ll want to make sure you figure out if an institution offers this account type before trying to open one.
Once you determine an institution offers a custodial IRA, you’ll need to look at other features.
Two of the most important things to look for are what you can invest in and the fees involved.
Some institutions may only allow you to invest a custodial IRA in savings accounts.
This would likely defeat the purpose of opening this account type.
Instead, you want to look for an institution that allows you to invest in low-cost investments that have the potential to grow over the long term.
This could be stocks, mutual funds, ETFs or other similar investments.
After all, you likely want the investments in your child’s account to outpace inflation.
Look out for fees
You also want to pay attention to fees. Chances are, your child isn’t going to have a lot of money to invest.
To maximize the growth potential, minimizing fees is vital. Make sure the account has little to no annual or maintenance fees.
Also, look at the fees investments charge.
Ideally, you’ll want to find a brokerage that doesn’t charge trade fees if you plan to invest in individual stocks.
If you prefer to invest in mutual funds or exchange-traded funds, look for low expense ratios.
Best Reasons to Open a Custodial IRA
You may want to open a custodial IRA for your kids for several reasons.
IRAs offer tax benefits depending on the type of IRA you open.
All IRAs offer tax-advantaged growth.
Traditional IRAs may allow your child to get a tax deduction in the year contributions are made.
In exchange, ordinary income taxes must be paid when withdrawals are made after age 59 and ½.
That said, most children pay little income tax so the deduction may not be the best idea.
Roth IRA contributions don’t give your child a tax deduction today. The real benefit comes when money is withdrawn.
Money withdrawn after age 59 and ½ in retirement is withdrawn completely tax-free. Unfortunately, withdrawing money before age 59 and ½ may incur penalties and taxes.
This means your child’s money may be locked up for decades. This does allow the power of compounding returns to have an insane effect on your child’s account balance, though.
Thankfully, some early withdrawal exceptions exist.
These may help children access the money early for a couple of significant financial events in their lives.
The power of compounding returns
The earlier someone starts investing, the more time they have for compounding returns.
Essentially, this is the concept of your earnings making even more earnings each year.
Let’s say you invest $1,000 today and earn a 10% return a year. You never add any additional money.
In year one, you earn $10. That means year two starts with $1,010. Now, that $10 you earned earns more money. And, 1% of $1,010 is $10.10. Essentially, you earn an extra $0.10 in year two.
This doesn’t seem like much but, over decades, it can have a considerable impact.
Using more impactful numbers, let’s say your child has $6,000 earned income per year starting at age 10. If you and your child decide to invest $500 per month ($6,000 per year) from age 10 through 17, that’s eight years of contributions.
In total, that’s $48,000.
At age 18, those contributions will be worth about $66,934 if you assume an 8% annual return. That’s over $18,000 more than they put into the account.
The real power of compounding shows up over decades, though.
Let’s say your child doesn’t touch the money until they turn 65. That $66,934 will turn into $2,839,062.
Essentially $48,000 of contributions will turn into almost 3 million dollars thanks to compounding returns.
Withdrawal exceptions may help
Your children can use the money within their IRA before age 59 and ½ for a couple of critical reasons without paying the early withdrawal penalty.
You may withdraw up to $10,000 penalty-free during your lifetime to help fund a first-time home purchase.
This sounds like a single opportunity, but the IRS defines a first-time home purchase as one when you haven’t owned a home during the previous two years.
The other major exception that may appeal to children is qualifying education expense withdrawals.
Withdrawals from an IRA used to pay for qualifying educational expenses for you, your spouse, or your child may avoid the 10% early withdrawal penalty.
Understanding what qualifies for these expenses is essential.
Your school must qualify first. If it doesn’t, you may end up owing the early withdrawal penalty.
Next, only some expenses qualify.
Typically, this includes things like tuition, fees, and books.
It may also cover room and board, but the qualifying student must be enrolled at least half-time for these expenses to qualify.
Withdrawals may still incur taxes, though.
To make sure you’re following the rules, it’s best to consult a tax professional before making a withdrawal.
Rules on Contributing to a Custodial IRA
Technically, the guardian manages the custodial IRA account. That said, there are still rules for contributing to this type of account.
First, the child must have earned income. Without earned income, such as money earned from a W-2 job, contributions cannot be made to an IRA.
Additionally, even children must follow the rest of the contribution rules for IRAs.
Typically, income limitations for deductibility or the ability to contribute to Roth IRA aren’t an issue. However, high-earning children could run into issues with these limitations.
As you’d expect, there are also contribution limits. Just like for adults under age 50, the maximum contribution to a traditional or Roth IRA for kids is $6,000.
How the Custodial IRA Transfers
As a custodial IRA, the custodian keeps control until the child reaches the age of majority in their state.
In most states, that’s age 18. In others, it is age 21.
Once the child reaches this age, the child must take control of the account. Essentially, the IRA changes from a custodial IRA to a regular IRA of the same type.
Then, they can do whatever they please with the money.
They can also change investments, cash out or move the account to another brokerage if they wish.
Consult an Expert
When you’re considering an investment product or service, you may have questions.
Some questions can be answered by your brokerage firm. This includes asking questions about how to open and maintain an account.
When it comes to financial advice, you’re better off consulting a fee-only financial planner.
These advisors can look at your financial situation and answer questions based on the specifics of your life.
These planners must give advice based on your best interests.
They aren’t influenced by commissions, either.
Instead, you pay for their advice with a flat or hourly fee.
This means the advice is free from conflicts of interest.
Opening a custodial IRA could set your children up for financial success.
Just make sure you understand how they work before you get started.