Custodial Roth IRA

A custodial Roth IRA is a Roth individual retirement account opened for a minor, owned by the minor and controlled by an adult who acts on the child's behalf until the child is legally able to manage it. It is an ordinary Roth IRA in every tax respect: contributions are made with after-tax dollars, and qualified withdrawals of the growth are tax-free. The name is a label used by the institutions that offer these accounts rather than a term defined in the tax code, which is why it can be confusing: the IRS uses "custodial account" to mean any IRA held by a bank or other approved custodian, and that has nothing to do with the account owner's age.

Two meanings of "custodial". In the tax code, "custodial" is a labeling device. IRC 408(h) treats a custodial account held by a bank or another approved institution as a trust, which is why the IRS model agreement for a Roth IRA held at a brokerage is Form 5305-RA, "Roth Individual Retirement Custodial Account." An adult with a Roth IRA at a brokerage has a custodial account in that sense. In the phrase "custodial Roth IRA", the word means something else: an adult is managing the account for a child who cannot yet contract or invest on their own behalf, in the way a custodian manages a minor's account under a state transfers to minors act. The adult opens the account, chooses the investments and signs the paperwork, but the money belongs to the child.

The eligibility test is compensation. The Roth IRA rules have no age floor. IRS Publication 590-A states that "contributions can be made to your Roth IRA regardless of your age"; what limits them is compensation. For a Roth IRA the maximum contribution for a year is the lesser of the annual limit, $7,500 for the current year, and the child's taxable compensation. Publication 590-A defines compensation as wages, salaries, tips, professional fees, bonuses and other amounts received for providing personal services, plus net earnings from self-employment, and lists what does not count, including interest, dividends and other earnings from property. Gifts are not compensation, and neither is an allowance that is not pay for genuine work. The test is "compensation", not "earned income", a related term with several other statutory definitions that is easy to reach for by mistake.

Proving the income. A W-2 from an employer settles the question. Pay for informal work, such as babysitting, lawn care or pet sitting for neighbors, counts too; when the child is working for themselves, it is measured as net earnings from that work. Keeping a dated record of who paid, for what and how much is what substantiates it. Once a child's net earnings from self-employment reach $400 for the year, self-employment tax applies and a return with Schedule SE must be filed, which also creates the record.

Who puts the money in. The Code sets the limit as an amount equal to the child's compensation; it does not require the contribution to be paid out of those earnings. So a parent or grandparent can supply the dollars, and the contribution is a gift to the child. A family with a teenager who earned $3,000 at a summer job can let the teenager keep the paycheck and fund up to $3,000 of Roth contributions itself.

When the child takes over. Control passes to the child at the age set by state law and the institution's account agreement; there is no single national age. After that the account is simply the young adult's own Roth IRA. Until then, the adult manages it for the child's benefit and cannot treat it as their own money.

What follows the ordinary Roth rules. Everything about taxes and withdrawals follows the regular Roth IRA rules, including the income limits for contributing, which a young worker rarely approaches. It is a different arrangement from a Trump account, a separate kind of IRA for children that the statute specifies is not designated as a Roth IRA.

Opening and funding one follows a short sequence.

1. Confirm the child has compensation for the year, from an employer or from self-employment, and keep the records.
2. Open the account at a brokerage or bank that offers accounts for minors, with the child as owner and an adult as the person managing it.
3. Contribute up to the lesser of the child's compensation and the annual limit, by the tax-filing deadline for that year, not counting extensions. The money can come from the child or from family members.
4. Invest and leave it. The adult chooses the investments until the child takes control.
5. Hand over the account when the child reaches the transfer age.

Take an example: Dario, 15, earns $2,500 bagging groceries one summer, reported on a W-2. His grandmother contributes $2,500 to a custodial Roth IRA for him, the most allowed because it equals his compensation. If the account earns 7% a year, a reasonable long-run assumption but not a promise, $2,500 grows to about $2,500 x 1.07^50, or roughly $73,600, over 50 years, by which time Dario is 65. Because the money went in after tax, a qualified withdrawal of all of it, growth included, would be tax-free. Had Dario earned $1,800 instead, the cap for that year would have been $1,800, no matter how much his grandmother wanted to give.

Pros

• Decades of tax-free compounding on money contributed while a young person's tax rate is low or zero.
• A parent or grandparent can fund it within the child's compensation, so the child can keep their paycheck.
• Roth contributions, unlike the earnings on them, can be withdrawn without tax or penalty, which keeps some flexibility.
• Teaches investing with real money in an account the child owns.

Cons

• Impossible without compensation, and informal work needs good records.
• The money becomes the young adult's to control at the transfer age, whatever the adult who funded it would prefer.
• A contribution is an irrevocable gift to the child.
• Few people at this stage need retirement money more than an emergency fund or education savings, so it competes with other goals for limited dollars.