Why would a parent want to open a Roth IRA for a child? What does this solve?
Most gifts we give to our children like bicycles or vacations or even automobiles depreciate in value or have no value later. A Roth IRA, if properly invested, will appreciate in value, and there will be something for that child later.
Since the child is starting earlier, they have an opportunity to use the magic of compound interest to grow the IRA to a very large amount, compared to somebody starting in adulthood.
The day will come where they will be very grateful to someone with the wisdom to do this on their behalf.
This will be either when they use the Roth IRA to help pay for college, in which case the funds can be pulled penalty free and original contributions tax-free, or at retirement when it will help provide comfortable income completely tax and penalty free.
What are the legal issues surrounding this? Age? Income?
As long as a child has earned income, they can buy a Roth IRA for up to $6000 per year at any age.
Someone else can also fund the Roth IRA for the child for up to $6000 a year, as long as the child has earned income equal to the amount contributed on their behalf.
If the child is legally a minor, which means in most states under 18 years of age, they will need to open a custodial Roth IRA, where the child is the account owner with an adult, usually a parent, serving as the custodian.
Contributions are reported to the IRS under the minors Social Security number but the custodian is the individual authorized to act on the account.
Are there any disadvantages or pitfalls to watch out for?
Putting money in a Roth IRA as a child has very few disadvantages.
One thing to look out for would be if the minor is not employed with a company and is not issued a W-2, but instead for example, mows lawns or shovels snow or babysits.
The custodian should document that the child received earned income that was reasonable. For example a parent should not pay a child $1,000 for shoveling the sidewalk one time.
What else should someone who is contemplating this strategy know?
For a younger child don’t get over concerned about putting the Roth IRA money in stocks or stock mutual funds, which historically have made the most money overtime, compared to putting it in things like bank CDs.
The best safety against market fluctuation is time, and for a younger child, statistically speaking, they will have a lot more time to average out the fluctuation of the market.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. IRA’s and ROTH conversions require understanding of specific rules, for complete rules on IRA’s (including who qualifies), please visit www.IRS.GOV Publication 590a or consult with a qualified professional.