Minor Roth IRA - A Powerful Savings Tool

A minor Roth IRA may be the single best thing (financially speaking) you can do for your kids. Combining a child’s long time horizon for investment and low tax bracket makes it one of the most powerful saving tools available.

No Age Limit

There is no age limit for opening one. Earned income is the only requirement, but the earned income has to be legit. Paying your kid to mow the lawn doesn’t qualify. It has to be actual earned income that is subject to income taxes.

Several years ago, my own teenager had income for the first time from a job after school, making her eligible to open a minor Roth IRA. I encouraged her to invest by sweetening the pot: I told her I’d match whatever she contributed. She contributed $500 (ouch!), and I kicked in $500.

Most folksand this includes my daughterare unaware the $1,000 contribution can be taken out by the owner(s) of the minor Roth IRA at any time, for any reason, without tax or penalty. You don’t have to be 59 1/2, wait 5 years, or even have a good reason. Since she is now 18+ and the custodial designation has been removed, she is free to do so.

By the way, if you see her, please don’t tell her this! Even though the contributions have earned lots of tax free earnings, she’s still just a kid. I’ve got a feeling Dad’s $500 might already have been spent by now if she knew. Better to leave it in there to accrue more tax free earnings!

Seriously, kids that age benefit most from Roth IRA contributions. First, most are in very low tax brackets. My daughter, in fact, didn’t owe any tax that year. It just made sense for her to get that tax liability, in this case zero dollars, “over with” in the year of the contribution.

Custodial Account Required

Kids under the age of majority (18 in most states) can’t legally own assets, but a minor Roth IRA custodial account in the interim does the trick.

A custodial account is no big deal. They are inexpensive, readily available, and the custodial designation is easily removed once the child reaches the age of majority. It simply involves a parent (or other adult) signing on to take responsibility for the account until the minor is of legal age.

Minor Roth IRA Example

What my daughter really has going for her is a long time horizon for investmentlet’s say 45 years. Figuring a 7% return on her money (compounded monthly) that $1,000 will turn into around $23,000. The $22,000 of earnings will be completely free from taxes, as well as the $1,000 contribution (which has already been subject to tax).

Had she instead made a traditional IRA contribution, both principal ($1,000) and earnings ($22,000) would be fully taxable at whatever federal, state, and local ordinary income tax rates apply in the second half of the twenty-first century. If I had to guess, I’d say they’re going to be higher than they are now.

Beware of High Investment Thresholds

More than likely your kids are going to start off investing small amounts. That’s perfectly OK. As the previous example illustrates, money contributed early on has quite a big bang for the buck. Even a few dollars will go a long way.

You may, however, run into some difficulty finding a financial institution that will accept such small amounts, especially initially. I had to shop around when looking where to open up my daughter’s minor Roth IRA account.

The trick is finding high performing mutual funds with low costs that don’t have high initial investment thresholds. T. Rowe Price is a good choice. Their fees are low, they have a good performance record, and most of their mutual funds have low $500 minimum investment thresholds. And setting up the custodial designation is a snap.

A list of mutual funds that have $50 or less minimums is maintained by The Mutual Fund Education Alliance (mfea.com), a good source of information on mutual funds.

Kids and Money

Besides helping to jump-start their retirement savings, a minor Roth IRA has another advantageteaching your kids financial literacy. Why simple skills like reconciling an account, basic investing, and the time value of money are not taught in our secondary schoolsor our colleges for that matteris beyond me.

That leaves the education up to you, the parent. Establishing a child Roth IRA will help you teach them those much needed life skills. When tax free earnings start piling up, kids take notice.

The Gift That Keeps on Giving

There is no finer gift to give your kids than those of wealth and financial literacy. Help them open up and manage a minor Roth IRA as soon as they have earned income. They’ll love you for it more and more as time goes by.