A Roth IRA isn’t typically considered a savings vehicle for kids, but it should be.
Roth IRAs are ideal for kids, because children have decades for their contributions to grow tax-free. And these accounts offer flexibility, too: Contributions to a Roth IRA can be withdrawn tax- and penalty-free at any time.
Quick facts about Roth IRAs for kids
There are no age restrictions. Kids of any age can contribute to a Roth IRA, as long as they have earned income.
A Roth IRA is more flexible than other retirement accounts because contributions can be withdrawn at any time.
» Check out our top picks for the best Roth IRA accounts (as noted above, many providers don't offer custodial Roth accounts)
The rules of Roth IRAs for kids
There's no age limit. Even the Gerber baby can contribute to a Roth IRA: The hurdle to opening this account is about income, not age.
The child must have earned income. If a kid has earned income, he or she can contribute to a Roth IRA. Earned income is defined by the IRS as taxable income and wages — money earned from a W-2 job, or from self-employment gigs like baby-sitting or dog walking. (If you want to contribute to your child's Roth IRA or match your child's contributions, that's fine as long as she has at least as much earned income as the total contribution amount.)
There are contribution limits. The Roth IRA contribution limit is $6,000 a year in 2020 and 2021, or the total of earned income for the year, whichever is less. If a child earns $2,000 baby-sitting in 2020, he or she can contribute up to $2,000 to a Roth IRA.
» Read more about how and where to open a Roth IRA
Here's how to open a Roth IRA for your kids
Your child’s income is what makes him eligible for the Roth IRA, but a parent or other adult will have to help open the account. Roth IRA providers typically require an adult to open and manage a custodial Roth IRA on behalf of a minor.
The process is simple and should only take about 15 minutes — you'll need to provide Social Security numbers for you and your child, birthdates and other personal information.
Why a Roth IRA can be right for kids
Now that you know whether your kids can have a Roth IRA, you might be wondering if they should. Aside from the momentum of investing early, there are several reasons why a Roth IRA in particular can be a good choice for children:
1. Contributions can be withdrawn at any time
Retirement accounts are known sticklers about distributions; many charge a 10% penalty on money taken out before age 59½. That’s tough on kids, who aren’t exactly known for their ability to delay gratification.
But a Roth IRA is different. The money contributed to the account can be withdrawn at any time and used for anything from a Matchbox car to a first real car.
That flexibility is balanced by stricter rules for the Roth IRA account’s earnings, or the return on contributions that are invested. Distributions of investment earnings may be taxed as income, penalized with a 10% early distribution tax or both.
Those two rules make the Roth IRA a nice middle ground between kids who want easy access to their cash and parents who want to make sure some of that cash is saved for the future.
» Get the full details on Roth IRA early withdrawals
2. More time means more growth
There’s a fun phenomenon called compound interest that works like this: Given time, invested money earns more money. Most of us have 30 or 40 years until retirement once we start investing; a kid who starts earlier has the benefit of much more. If your kids leave their money in the Roth IRA until retirement, they could be looking at 50 or more years of investment growth, completely tax-free.
Is waiting that long a hard sell? Maybe mention that a one-time contribution of $6,000 in a Roth IRA -- with no additional contributions at all -- would grow to about $200,000 in 60 years (assuming a 6% investment return and monthly compounding).
3. Investing trumps saving
That type of growth wouldn’t happen in a plain savings account, which is the more traditional choice for kids because it’s flexible and doesn’t require earned income. Unlike in a Roth IRA, birthday money is welcome.
But a Roth IRA allows your kids to pick and choose investments, which, over the long term, can lead to the kind of growth described above. Savings accounts instead pay a relatively flat interest rate that currently hovers around 0.09%. That’s a far cry — and many thousands of dollars — from the 6% or more you can expect to earn annually from a long-term investment. Even at a 1% interest rate — paid by many online savings accounts today — a one-time deposit of $6,000 won’t even double after 60 years.
There are trade-offs, of course: Most notably, your kids could lose the money they invest in a Roth IRA, though history tells us that’s unlikely to happen if they stick to a diversified portfolio over a long period of time.
4. The tax advantages are prime for kids
The Roth IRA works like this: Because there’s no tax break for putting money into the account, qualified distributions in retirement are not taxed. All that growth we keep talking about is earned completely tax-free if your kid follows the rules for distributions.
The Roth’s tax treatment is especially valuable when your time horizon is long and your current tax rate is low, and both of those are true for children. In fact, the earnings of most kids are so low that they pay little to no income taxes, meaning they avoid taxes on contributions, too.
5. The money can be used for more than retirement
Yes, a Roth IRA is a retirement account. The ideal goal is to sit on the account and allow it to accumulate a nice pot of cash over time. But it’s worth pointing out that a Roth IRA isn’t just a retirement account.
Again, contributions can be pulled out any time, for any reason. But there are also a couple of loopholes that can get your kid access to the investment earnings before age 59½.
After the Roth IRA has been funded for five years, your child can take out up to $10,000 in earnings to buy a first home, tax- and penalty-free.
Roth IRA earnings can be used for qualified education expenses, like college tuition. Earnings distributed will be taxed as income, but there will be no penalty.