Many grandparents go above and beyond to offer financial help to adult children and grandchildren. If you’re seeking to contribute to your grandkids’ financial future, one option might involve opening a custodial Roth IRA on your grandchild’s behalf as soon as he or she starts reporting earned income.
While grandparents often find 529 college savings plans advantageous for their personal estate planning as well as supporting their grandchild’s educational future, custodial Roth IRAs may allow for more flexibility depending on the child’s future needs. For example, a young adult may use tax-free Roth IRA proceeds to fund education expenses not covered by savings or a down payment on a first home. Roth IRAs may also be a useful and collaborative savings tool for important expenses young adults have, such as continuing education or a down payment on a first home.
Unlike traditional IRAs, Roth IRAs are funded with after-tax dollars. That means the account holder doesn’t get a tax break at the time of initial or successive deposits, but the money grows tax-free and can be withdrawn tax-free – a benefit for a grandchild who may need a substantial sum in the years to come. Learn more about Roth IRAs by watching this Khan Academy video.
Here’s an example of how much an initial $2,000 deposit in a Roth custodial IRA can grow. For an account opened at the time the child is 16, the $2,000 opening deposit – without any more money added to the account – could be worth roughly $55,000 at the time the child reaches age 65 assuming a 7 percent expected rate of return.
What if the child needs to make a tax-free withdrawal sooner, such as at age 35, for example? Based on the same earnings calculation as above, he or she would receive a less impressive sum of roughly $7,200. Of course, it remains a potential solution if there is a severe need for cash.
In 2015, the annual contribution limit for all IRAs is $5,500. It is possible, though not that easy, for a minor to open a Roth IRA on his or her own, which is why it’s good for grandparents – or any qualifying friend or relative – to shop for custodial accounts with low fees and low investment minimums to start. This is compounded annually.
As you evaluate a decision to open a custodial Roth IRA, check with the broker and the account administrator on any institutional or state rules on custodial accounts and what information you’ll need to open one. Depending on those rules, there’s a chance that grandparents may not be able to open the custodial account directly and you will have to work through their parents or legal guardian to get started.
Also, consider the following:
Make sure you’re financially secure. The MetLife study notes that many grandparents tend to overextend their financial support when it comes to family members in need. Seek advice from financial, tax and estate professionals on how much you can reasonably afford to give and the best means to do so.
Coordinate with your grandchild’s parents or guardian. It is important for family members to remain open about all money issues, particularly in relation to minors. Discuss what provisions the parents have made for the child and whether your idea complements financial strategies already in place. If not, keep talking and discuss other ways you can help.
Consider your grandchild’s potential handling of the account. When your grandchildren reach legal age or meet other key requirements of the account, they can take control of the money. Will they be ready? If not, evaluate other investment vehicles that better meet your objectives.
Bottom line: Setting up a custodial Roth IRA may be a good way for grandparents and grandchildren to work on retirement or other financial goals.