How to Fund Your Kids' Inheritance Now

“Junior” needs a job

To open a Roth IRA, your child must have earned IRS reported income this year, be it from a full, part-time or temporary job. We even had a client whose child was so beautiful that she modeled baby clothes as soon as she could sit up, so we established a Roth IRA for a nine-month old!  

You may be thinking, “That summer job money is long gone.” That’s OK. The IRS doesn’t track the source of the money that funds the Roth. It truly can come from anywhere—from you, from grandparents, from the child’s savings account. The contribution just can’t be more than what the child earned in the year (or more than the allowed annual maximum contribution, which is $6,000 in 2020 and 2021 for anyone younger than 50).

Harness the power of time

The biggest benefit of a Roth IRA for kids comes from the amount of time the money will be in the account. This provides a lot of potential for growth—especially if there are annual contributions to the account.

Let’s say, for instance, that you start a Roth IRA for your newly employed 16-year-old daughter, and you put $2,500 into the account. If you do nothing else—no other contributions and no withdrawals—that account would be worth $117,000 by the time she’s 66. That’s assuming an 8% average annual return.

But look what happens with ongoing deposits of just $2,500 per year over 50 years—an ending balance of over $1,500,000! And this number gets astronomically bigger if you and/or your daughter max out her contributions once she is works full-time. As noted above, the maximum contribution in 2020, and 2021, is $6,000.

Potential Growth of a Roth IRA over Time 

Initial deposit at age 16

Annual deposits

Balance at age 66*

$2,500

$0

     $117,254

$2,500

$2,500

  $1,551,679

*Assumes year end investment and an 8% average annual return.

The ABCs of Roth IRAs

There’s no minimum age for Roth IRAs. As long as an individual has earned income, they can contribute to a Roth IRA. That said, if your child is younger than 18, you’ll need to set up a custodial Roth IRA. That just means that you control the account until your child is of age.

But you can earn too much money and not be eligible to contribute to a Roth IRA. For singles in 2020, anyone who earns up to $124,000 is eligible to fully contribute to a Roth IRA. That limit increases to $125,000 for 2021.

This is another reason why generational planning is so important, because while Mom and Dad may earn too much to be eligible to have a Roth (married couples tap out from full Roth contributions at a joint income of $196,000 in 2020; $198,000 for 2021), most every kid at some point can.  This “phase-out of eligibility” is why it’s so important to contribute every single year that earnings are within the Roth limits! 

One of the biggest advantages of Roth IRAs is that they’re funded with after-tax income [unlike a traditional IRA or a 401(k), which are funded with pre-tax income]. That’s great for young people, since their tax rate is probably as low as it will ever be in their lives.

Funds withdrawn before age 59 ½ years old are subject to a 10% withdrawal penalty. But there are exceptions where funds can be taken out penalty-free:

  • First-time home purchase
  • College expenses
  • Birth or adoption expenses

Retirement withdrawals are tax-free! Since contributions to Roth IRAs have already been taxed, your child won’t have to pay taxes or penalties on the money when they withdraw it later in life—as long as they meet these requirements when they make a withdrawal:

  • They’re at least age 59½.
  • The contributions have been in the account for at least five years.

Post-tax contributions also mean no required minimum distributions (RMDs). So your child can leave that money in the account indefinitely. (Traditional IRAs, on the other hand, require RMDs starting at age 72.)

Opening an account

Like any investment, it’s important to pay attention to the details of a Roth IRA. Fees, investment options, investment minimums and more should be considered. If you’d like help finding the right Roth IRA, we can help. Just contact us to start the conversation.