Custodial Roth IRAs have become popular for parents looking to help their children build their savings. These accounts offer a combination of tax benefits and flexibility, allowing young people to start saving and investing early.
However, when it comes to selecting the most suitable savings vehicle for your children, parents have a number of options in addition to a Custodial Roth IRA, such as traditional Custodial accounts and 529 Plans. Here’s what to know when choosing between these accounts.
Key Takeaways
- Traditional Custodial accounts offer a high degree of flexibility and a wide range of investment options. They are set up for the benefit of a beneficiary by a responsible adult.
- A Custodial Roth IRA is opened for a minor with earned income, allowing future tax-free growth and withdrawal.
- Roth IRAs can be an excellent choice for children as they offer the advantage of many years for contributions to grow tax-free.
- There are no restrictions on having multiple savings accounts for your child. You can combine a Custodial Roth Account, a Traditional Custodial Account, and a 529 Plan.
What Are Traditional Custodial Accounts?
Before diving into what a Custodial Roth IRA is, let’s first review a traditional custodial account.
Custodial accounts, also known as UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) accounts, were created under state laws to hold gifts or transfers of funds to a minor.
UTMA is a type of custodial account that can hold many kinds of assets, including real estate, intellectual property, and works of art. UGMA, on the other hand, is limited to financial assets of cash, stocks, bonds, mutual funds, exchange-traded funds, CDs, annuities, and insurance policies. All states allow UGMA accounts. However, South Carolina and Vermont don’t allow UTMA accounts.
Typically, parents or grandparents open a custodial brokerage account to save for a child’s future or make financial gifts to the child. They’re often used by affluent families where parents or grandparents want to remove money from their taxable estates by gifting it to the younger generation.
Custodial accounts are set up for the benefit of a beneficiary by a responsible adult (the legal guardian or custodian). Once you deposit funds into a custodial account, you cannot access or withdraw the money for yourself, as it becomes the property of the minor recipient.
The custodian typically has access to and control over it until the minor reaches the age of majority. The assets, both its principal and any earnings, become the minor’s property when they reach the age of majority, typically between 18 and 25.
Here are some key features of Custodial Accounts:
- Contribution Limits- There are no contribution limits. However, the annual gift tax exclusion applies in the same way it does to other types of gifts.
- Qualified Withdrawals- Funds must be used for any purpose that directly benefits the child, such as education, housing, or medical expenses. However, the money can be used for any purpose once the child reaches the age of majority.
- Investment Options – Just like regular brokerage accounts, you can access the same array of investment options, from exchange-traded funds (ETFs) and mutual funds to individual stocks.
- Taxes on income- Generally taxed at the child’s income tax rate. The first $1,050 unearned income from UTMA/UGMA accounts is tax-free. The next $1,050 is taxed at the child’s income tax rate, which is typically 10%. Any unearned income over $2,100 is taxed at the parent’s income tax rate.
Now that we’ve reviewed what a Traditional Custodial Account is, let’s look at its alternative: Custodial Roth IRA.
What is a Custodial Roth IRA?
A Custodial Roth IRA is a tax-advantaged retirement account in which a parent, grandparent, or any other adult opens on behalf of a minor.
Contributions to both traditional Custodial accounts and Custodial Roth IRAs are made after tax. That means they aren’t tax deductible and don’t reduce your taxable income in the year you make them.
A Roth IRA is designed as a retirement savings account, and the account holder must generally be at least 59 1/2 years old to withdraw from the account without incurring penalties.
Furthermore, the Roth IRA account must have been established for at least five years from the first contribution date. If these conditions are not met, a 10% penalty is applied to early withdrawals.
Some exceptions allow your child to access the investment earnings before reaching age 59 1/2:
- First-time homebuyer exception: After your child’s Roth IRA has been funded for five years, they can withdraw up to $10,000 in earnings to purchase their first home. This withdrawal is tax and penalty-free.
- Qualified education expenses: Roth IRA earnings can be used to cover qualified education expenses, such as tuition, fees, and books at eligible educational institutions. While these withdrawals will be taxed as income, they won’t be subject to any additional penalties.
Who Can Open A Custodial Roth Account?
A Custodial Roth IRA can be opened for a minor with a yearly income.
Minors generally cannot open brokerage accounts in their own name until they are 18. This is why a Custodial Roth IRA requires an adult to serve as the custodian. The custodian maintains control of the child’s Roth IRA, including decisions about contributions, investments, and distributions.
Who Controls A Custodial Roth Account?
The age of majority and the age of termination are two different aspects that come into play with Custodial Roth IRAs, where the account must be converted to a regular Roth IRA in their own name.
The age of majority is when an individual is legally considered an adult and can sign contracts. This age is often 18 but can vary depending on the state. When a child reaches the age of majority, they can take control of the Custodial Roth IRA. But this transfer of control can only happen with the custodian’s consent. This means that even though the child is legally an adult, they cannot take control of the account independently without the custodian’s agreement.
On the other hand, the age of termination is the age at which the custodian is legally required to transfer control of the account to the child. This age is usually 21, but it can be up to 25, depending on the state. When a child reaches the age of termination, they can remove the custodian from the account and take full control, regardless of whether the custodian consents.
Pros of Custodial Roth Account
Tax-Advantaged
Since Custodial Roth Accounts are funded with after-tax dollars, the investment growth and qualified distributions during retirement are tax-free.
The account holder can withdraw the contributions and earnings tax-free after they reach 59 1/2 years old and have held the account for at least five years. This feature makes it an attractive option for long-term growth and a tax-efficient way to transfer wealth later.
Wide Investment Options
The funds in a Custodial Roth IRA can be invested in various assets, just as with any Roth IRA. Investments can include stocks, bonds, mutual funds, and ETFs. The investment strategy should be tailored to the child’s age, risk tolerance, and investment goals. The investment strategy can always be adjusted as the child ages or their investment goals change. This provides more.
Legacy Planning
If your child doesn’t need the funds for immediate expenses, they can continue growing the account and even pass it on to their own children or beneficiaries tax-free.
Cons of Custodial Roth Account
Qualified Use of Proceeds Is Not as Flexible
A Roth IRA is designed as a retirement savings account, and the account holder must generally be at least 59 1/2 years old to withdraw from the account without incurring penalties.
In contrast, traditional Custodial Accounts have no restrictions on how the funds can be used as long as they benefit the child. Once the funds are deposited into the account, they are considered an irrevocable gift to the child. This means you can use the funds for non-education-related expenses such as medical bills, a down payment on a house, or any other expense that directly benefits the child.
Income Limit
A Custodial Roth IRA can be opened for a minor with a yearly income. This income can come from formal employment or self-employment. Income earned from babysitting, performing, working in businesses owned by their parents, or other freelance work can qualify a minor for Roth IRA contributions.
Custodial Accounts, on the other hand, have no income limit.
Low Contribution Limits
The current maximum annual contribution is $6,500, or the total of a child’s earned income for the year—whichever is less. For example, if your daughter earned $2,000 during a summer job, she could contribute up to $2,000 to her Custodial Roth IRA.
In contrast, there are no contribution limits to Custodial accounts.
Custodial Roth vs 529 Plans: What’s the difference?
Like a Custodial Roth Account, a 529 plan is a great way to save for your child. Distributions from 529 accounts consist of after-tax contributions and earnings.
However, unlike Custodial Roth, the earnings portion for a 529 plan is not taxed only if used to pay for qualified education expenses. However, any money distributed for any purpose other than education is subject to taxes and a 10% penalty on the earnings portion of the distribution (not on the principal portion). This means that if you withdraw funds for an unqualified expense, you’ll incur a 10% penalty and have to report those funds as income on your state and federal taxes.
Further, the beneficiary of a 529 plan does not automatically gain control of the account unless he or she is also the account owner. This means that the person who contributed the money controls the 529 account.
Another difference is that 529 plans can hold assets indefinitely as long as a living beneficiary is listed. This means that an original beneficiary could change their education plans and go back to school later in life, or they could have their own children and name those children as the new beneficiaries of the plan.
529 plans offer various investment options for different risk tolerances and investment goals. Common investment choices include age-based portfolios, static Portfolios, bank products, and mutual funds. However, 529 plans are more limited in how funds can be spent than Custodial Accounts.
Can I have a Custodial Roth IRA, a Traditional Custodial account, and a 529 Plan?
There are no restrictions on having multiple savings accounts for your child. Combining these accounts can be a strategy to maximize your child’s savings potential and flexibility. Each of these accounts has its own rules and benefits, and you can contribute to each as long as you observe the contribution rules for each type of account.
How do you open a Custodial Roth IRA Account?
Opening a Custodial Roth IRA account can be done through many major online brokers, including Fidelity, Vanguard, Charles Schwab and can be set up online.
Here are the general steps:
- When choosing an institution, look for one that offers a wide range of investment options, has low fees, and has a user-friendly online interface.
- You’ll need to provide Social Security numbers for you and your child, birthdates, and other personal information.
- After you’ve opened the account, you can fund it by transferring money from your bank account.
- Before your child turns 18, you should check with your brokerage firm about the account’s age of majority and termination.
How do you invest in a Custodial Roth IRA Account?
After you’ve opened and funded your child’s Custodial Roth IRA, deciding on the investments should be based on the child’s age, risk tolerance, and financial goals.
For younger children, you might opt for a more aggressive investment strategy with a higher proportion of stocks, which have the potential for higher returns over the long term. Low-cost ETFs or mutual funds that track the entire S&P 500 or the entire U.S. stock market are generally a good choice for your child’s investment portfolio, given their long time horizon.
It’s also worth considering target-date funds, which automatically adjust the investment’s asset mix based on a specified target date (typically the year the child will turn 18).
Custodial Roth IRA vs. (UGMA/UTMA) vs 529 Table (2024)
| Aspect | Custodial Roth IRA | Custodial Account (UGMA/UTMA) | 529 Plans |
| Eligibility | Child must have earned income. | No income requirement. | No income requirement. |
| Contribution Limits | Lesser of child’s earned income or annual contribution limit ($7,000 in 2024). | No contribution limits, but the annual gift tax exclusion applies. In 2024, you can give up to $18,000 per year to an individual without incurring federal gift tax. If you’re married and both you and your spouse are contributing, you can give up to $36,000 in 2024. | Contribution limits vary by state; typically ranges from $235,000 to $550,000. The annual gift tax exclusion applies. In 2024, you can give up to $18,000 per year to an individual without incurring federal gift tax. If you’re married and both you and your spouse are contributing, you can give up to $36,000 in 2024. |
| Withdrawal Rules | Contributions can be withdrawn at any time. Earnings can be withdrawn tax-free after age 59 1/2 and the account has been open for at least 5 years. | Funds must be used for the benefit of the minor. This means that the money can be used for any purpose that directly benefits the child, such as education expenses, housing costs, or medical expenses. Money can be used for any purpose once the child reaches the age of majority. | Qualified distributions from a 529 plan are entirely tax-free. Money must be used for education expenses. Starting in 2024, unused funds can be rolled over to a Roth IRA without penalties, subject to certain conditions. |
| Age Limits | There are no age limits for Custodial Roth IRAs. Minors cannot generally open brokerage accounts in their own name until they are 18, so a Custodial Roth IRA requires an adult to serve as custodian. | There are no age limits for contributing to a Custodial Account. | There are no age limits for recipients and money can be held in the plans indefinitely. |
| Account Control | The custodian maintains control of the child’s Roth IRA, including decisions about contributions, investments, and distributions. When the minor reaches a certain required age, typically either 18 or 21 in most states, the assets must be transferred to a new account in their name. | The custodian is in control of the child’s custodial account until the child reaches the state’s age of majority. Depending on the state of residence, this is generally between 18 to 25. | The account owner maintains control over the management and disbursement of assets in a 529 plan. Only the owner can request account changes or withdrawals. |
| Taxation | Contributions are not tax-deductible. Earnings grow tax-free. | Contributions are not tax-deductible. The first $1,250 of unearned income is tax-free, the next $1,250 is taxed at child’s rate, and amounts above $2,500 are taxed at the parent’s rate. | Contributions are not tax-deductible, but earnings grow tax-free. |
| Investment Choices | Wide range of financial assets such as cash, stocks, ETFs, bonds, mutual funds. | UGMA Accounts: Wide range of financial assets such as cash, stocks, ETFs, bonds, mutual funds. UTMA Accounts: Virtually any type of asset, including real estate, equities, physical commodities, and works of art. | Various types of mutual funds, bond funds, and exchange-traded fund portfolios, but limited by the plan’s offerings. |
| Restrictions | Must have earned income. | None. | Must be used for education expenses. |
| Penalties | Early withdrawal of earnings may incur taxes and penalties. | None. | Non-qualified withdrawals may incur taxes and penalties. |
Final Thoughts
Custodial Roth IRAs combine the flexibility of traditional Custodial accounts with the tax benefits of Roth IRAs. Deciding whether a Custodial Roth IRA is right for you will depend on several considerations.
A Custodial Roth IRA is a great option if the child has earned income. It provides flexibility in terms of how the funds can be used. It also has the advantage of the beneficiary not needing to pay income tax on any of the withdrawals they make in future decades.
Another added benefit is that a Custodial Roth IRA can be a financial tool that can provide your children with a head start in understanding the value of saving and investing.
