Great tax advantage if you follow rules

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A Roth IRA can be a great investment choice for teenagers, but there are rules to follow.

A Roth IRA can benefit workers of every age, including children, but kids can’t open and control their own Roth IRA until they reach the age of maturity, which is 18 in most states.

To get around that age restriction, parents can open a Roth IRA for Kids that they manage until their child is legally old enough to take over the responsibility. These accounts aren’t right for everyone, but they offer advantages that can make opening one up for your child smart.

What’s a Roth IRA?

Unlike contributions to a traditional IRA, Roth IRA contributions aren’t tax-deductible. Instead, Roth IRAs are funded with after-tax contributions that can be withdrawn free of penalties and income taxes at any time.

A Roth IRA’s big advantage, however, is that earnings on contributions grow tax-free and earnings can be withdrawn tax- and penalty-free if a few rules are followed:

Alternatively, withdrawals must qualify for a certain exemption, such as a down payment on a first home, with a lifetime maximum allowance of $10,000.

The amount that can be contributed to a Roth IRA depends on two things: The account owner’s earned income and the Internal Revenue Service’s annual contribution limit.

Specifically, workers can contribute up to their earned income or the Roth IRA contribution limit, whichever is lower. If you’re under 50, the maximum contribution to a Roth IRA is $5,500 in 2018, so a person with $2,000 in earned income can contribute up to $2,000 this year, and a person with earned income of $7,500 can contribute up to $5,500 this year.

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What’s a Roth IRA for Kids?

A Roth IRA for Kids is a custodial account that offers the same contribution and withdrawal features as a regular Roth IRA.

If you want to open a Roth IRA for Kids for your child, your child will need to have earned income from work, such as a part-time job or a babysitting gig. Like a regular Roth IRA, contributions can’t exceed the child’s earned income or the annual contribution limit.

Once you’ve opened the account, you’ll be responsible for managing it for your child’s benefit until the child reach your state’s age of maturity. It’s important to remember is that any money contributed to a Roth IRA for Kids becomes the child’s money. You can’t take the money back, no matter how bad the child ends up being at managing finances later on. 

The earlier you start, the better

A Roth IRA’s best feature is tax-free, compound growth, or the ability to earn returns not only on your contributions, but also on your previous gains. Because returns are calculated on all past contributions and returns, each additional year an account is open can translate into substantially more money.

For example, let’s say Stephanie opens a non-interest-bearing savings account for her son Joshua when he’s 15 years old. They contribute $500 to this account up front, and then they add $50 to the account every month. In 10 years, Joshua would have $6,500 in savings. Not bad, right?

Now, let’s assume Stephanie contributes the same amount to a Roth IRA for Kids and that account earns a 6 percent average annual return. Joshua would wind up with $8,804 after 10 years because of compounding, or $2,304 more than he’d have accumulated in the savings account.

The benefit of compound growth increases over time, too.

For instance, if, after Joshua assumes control of his Roth IRA for Kids at his age of maturity, he continues contributing $50 per month until age 65, and he earns an average 6 percent annual return, then his $30,500 in contributions would grow to $183,411.62 because of compounding.

Rules you need to follow

The five-year rule for Roth IRAs means any withdrawals of earnings on contributions are subject to income tax and a 10 percent penalty if they occur before the five-year anniversary of the opening of the account.

There’s no getting around the 10 percent penalty if the five-year rule isn’t met, but if five years has passed, then you can avoid the 10 percent penalty on earnings in some situations, such as if the money is used for college tuition or to pay certain medical costs. Also, if the account is open for five years, you can avoid income tax and the penalty if the money is used for a qualified first-time home purchase.

Withdrawals of contributions can be considered income on future financial aid applications, though, which can reduce your child’s aid package, and income tax still applies to Roth IRA for Kids earnings that are withdrawn for tuition, so this isn’t the best vehicle for college savings. A 529 plan may be a better option for that. 

Roth IRAs don’t have to be reported on a college student’s Free Application for Federal Student Aid (FAFSA), though, and since that form determines how much money a student must pay toward education to receive federal aid, it can be a good place to park a child’s assets. Having said that, some schools do include IRA balances in their calculation, so you’ll want to ask how each college handles IRA’s before your child applies for admission.

Overall, a Roth IRA for Kids can be an excellent way to teach your child about investing, and it can give your child a big head start in the race to financial freedom, particularly if the account eventually helps that child buy a first-home that he or she otherwise couldn’t afford, or if the child hangs on to the account until his or her golden years.

 

The Motley Fool has a disclosure policy.

The Motley Fool is a USA TODAY content partner offering financial news, analysis and commentary designed to help people take control of their financial lives. Its content is produced independently of USA TODAY.

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