6 Mistakes To Avoid When Setting Up Your Child's Roth IRA | Mora

Establishing a Custodial Roth IRA for your child is one of the smartest financial decisions you can make. With tax-free growth, unmatched flexibility, and decades of compounding potential, it’s a powerful way to set them on the path to lifelong financial security.

However, navigating the setup process requires attention to detail - overlooking key steps can lead to missed opportunities or costly mistakes. 

In this article, we will look at:

• Why Choose a Roth IRA for Your Kids & The Key Benefits?
• 6 Common Mistakes To Avoid When Setting Up Your Child’s Roth IRA
• How To Set up a Custodial Roth IRA Without Mistakes
• Step-by-Step Guide to Setting Up a Custodial Roth IRA

Why Choose a Roth IRA for Your Kids?

Choosing a Roth IRA for your child is more than just saving for their future - it's giving them a powerful head start. A Custodial Roth IRA is hands down the best tool to build tax-free wealth, providing your child with the flexibility, financial security, and growth potential that other accounts just can’t match. 

Here’s why a Roth IRA is the ultimate choice for securing your child’s financial future:

• Tax-Free Growth: Gains in a Roth IRA grow entirely tax-free. In a standard brokerage account, up to 50% of your investment gains may go toward taxes over time, but with a Roth IRA, all growth remains yours to keep.
• Compound Interest: Your child has decades to benefit from compounding, which Benjamin Franklin described as “Money making money. And then the money that money made, makes money.” Compounding allows small contributions to grow exponentially over time, creating substantial wealth by retirement.
• No Required Minimum Distributions (RMDs): Roth IRAs don’t require mandatory withdrawals, so your child’s savings can grow tax-free for as long as they stay invested.

Learn more about Custodial Roth IRA in our article ‘Why a Roth IRA Is the Best Investment Account for Kids’.

Common Mistakes To Avoid When Setting Up Your Child’s Roth IRA

By being aware of these common mistakes when setting up your child's Roth IRA and addressing them early, you can ensure it is set up for long-term success, providing a solid foundation for their financial future. Here’s the six most common pitfalls to avoid:

1. Lack of Earned Income

The foundation of any Roth IRA is earned income-money that’s been earned from real taxable work, like part-time jobs, babysitting, lawn care, or freelance tasks. The IRS requires that contributions to a Roth IRA come from earned taxable income, not gifts or allowances. 

• What Counts as Earned Income: Work that generates taxable income, whether it’s traditional employment or small side jobs, qualifies. For traditional jobs, wages are typically reported on a W-2 form, while income from self-employment may be reported on a 1099 form. Think babysitting, dog walking, or even helping with a family business (paid fairly, of course). 
• What Doesn’t Count: Passive income sources, like investment dividends, allowances, or gifts, don’t qualify as earned income for Roth IRA contributions.
• Why It Matters: Without earned income, contributions to a Roth IRA are ineligible, which can lead to issues with the IRS and potential penalties. Additionally, maintaining a record of this income can prevent headaches in case the IRS requests verification.

Deborah Horwith, Registered Chartered Professional Accountant, breaks down what can be considered income for your child.

2. Exceeding Contribution Limits

Contribution limits for Roth IRAs are set by the IRS and are updated each year. For 2024 and 2025, the maximum annual contribution for individuals under 50 is $7,000. 

However, there’s an important detail for minors: contributions to a child’s Roth IRA cannot exceed the total amount of their earned income for the year.

• How to Avoid This Mistake: Calculate your child’s total earnings first. For example, if your child earned $2,500 from a part-time job this year, their maximum allowable contribution is $2,500—not the IRS limit of $7,000. Any contributions above your child’s actual earnings will be considered “excess contributions” and may result in a 6% penalty each year until corrected.

3. Neglecting Documentation of Income

For children earning money from informal work without official tax documentation, like freelancing or babysitting, it’s essential to keep accurate records. 

Without solid documentation, proving the legitimacy of your child’s contributions can be challenging if the IRS ever questions it. Here’s what you’ll need:

• Job Description: A brief overview of the tasks and responsibilities performed by your child helps verify that it’s real work.
• W-2 or 1099 Form: If your child is an official employee, you’ll need to issue a W-2. If they're contracted, a 1099 form works. These forms show earned income, which qualifies them to contribute to a Roth IRA.‍
• Time Sheets: Documented hours worked to show a regular schedule.‍
• Pay Stubs: Records of payments issued to your child.‍
• Employment Agreements: An agreement outlining duties, responsibilities, and pay.‍
• Compliance with Child Labor Laws: Ensure your child’s work aligns with federal child labor laws.‍
• State-Specific Requirements: Depending on your state, additional filings or compliance steps may be needed.

Anthony Kim, Tax Attorney & Partner at Kim & Rosado, breaks down what documents are needed to show employer relationship.

4. Misunderstanding Custodial Responsibilities

A Custodial Roth IRA means that, as the custodian, you control the account while your child is a minor. However, it’s your responsibility to manage the funds solely for their benefit. 

Misusing the account or failing to transfer control when they reach the age of majority (usually 18 or 21) can lead to complications and even legal issues. Here’s how it operates:

• You Are the Custodian: As the parent or guardian, you control the account and make all investment decisions while your child is a minor. This allows you to guide the investment strategy and maximize growth based on your financial knowledge.
• Transfer of Control at Adulthood: When your child reaches the age of majority (usually 18 or 21, depending on your state), the account transitions to their control. They gain full ownership and can make their own investment decisions and withdrawals as they see fit, ending your role as custodian.

This setup also builds financial responsibility and provides an account designed for both immediate needs and long-term security.

5. Overlooking Tax Implications of Withdrawals

One of the benefits of a Roth IRA is its flexibility with withdrawals, making it a powerful option for your child’s future. 

Contributions (not earnings) can be withdrawn at any time, tax and penalty-free. However, early withdrawals of earnings may incur taxes and a 10% penalty unless they meet specific criteria. Here’s what you should know:

• Contributions: You can access contributions anytime, tax- and penalty-free. Since they’re funded with after-tax dollars, this money is always available when needed.
• Qualified Withdrawals (Earnings): Earnings are tax- and penalty-free after 5 years if:
  • The account holder is 59½ or older.
  • The funds are for a first-time home purchase (up to $10,000).
  • The account holder becomes disabled.
  • Beneficiaries receive the funds after the account holder’s death.
• Early Withdrawals of Earnings: If withdrawn before 5 years or without meeting specific criteria, earnings may incur taxes and a 10% penalty.

Exceptions That Avoid Penalties: Even if the 5-year rule isn’t satisfied, penalty-free withdrawals of earnings are allowed for:

• Qualified education expenses.
• Medical expenses exceeding 7.5% of adjusted gross income.
• Health insurance during unemployment.
• Birth or adoption expenses (up to $5,000).
• IRS levy situations.

Deborah Horwith, Registered Chartered Professional Accountant, explains When Can You Withdraw From a Roth IRA?

6. Failing to Educate Your Child About Their Roth IRA

A Custodial Roth IRA isn’t just an account - it’s an opportunity to teach your child valuable financial skills. Many parents open a Roth IRA with great intentions but miss out on including their child in the process, leaving them unprepared to manage the account when it’s theirs to control.

• Why Involvement Is Key: Involve your child in managing the Roth IRA to help them understand the basics of saving and investing. Explain the concepts of compound interest, tax-free growth, and long-term savings. This builds confidence, financial literacy, and a sense of ownership over their future.
• The Long-Term Benefit: Educating your child on the “why” and “how” of their Roth IRA fosters responsible financial habits. When it’s their turn to take control, they’ll be better prepared to make smart decisions that keep their nest egg growing.

Deborah Horwith, Registered Chartered Professional Accountant, explains how a custodial Roth IRA can teach kids financial responsibility.

How To Set up a Custodial Roth IRA Without Mistakes

Setting up a Custodial Roth IRA is a straightforward process and only requires a few essential steps to get your child on the path to tax-free growth. Here’s a brief overview:

• Ensure Your Child is Eligible: The IRS requires that the child has earned income to contribute to a Roth IRA.
• Choose a Trusted Financial Provider: Research financial institutions offering low fees and diverse investment options like Fidelity or Charles Schwab.
• Gather Required Documentation: To meet IRS requirements, establish documentation that proves a legitimate working relationship.
• Set Up Contributions: Once the account is live, it’s time to fund it.

For a more in-depth comprehensive guide check out our article ‘Setting Up a Roth IRA for Your Kids: A Step-by-Step Guide’.

How Mora Simplifies Setting Up a Roth IRA for Kids

Setting up a Roth IRA for your child can feel overwhelming—but it doesn’t have to be.

Mora’s expert team simplifies the process by helping you organize necessary documents, ensuring compliance, and crafting a strategy tailored to your child’s future.We’re here to make financial planning stress-free, so you can secure tax-free retirement savings for your kids.

Mistakes When Setting up Custodial Roth IRA Savings Account FAQs

• Can I contribute to my child’s Roth IRA if they don’t have earned income?
  No, only the child’s taxable income earned from a job or self-employment qualifies for Roth IRA contributions - not gifts or allowances. Be sure to track and document your child’s earned income. 
• What happens if I accidentally contribute more than my child’s earned income?
  Excess contributions can result in a 6% penalty each year until corrected. If you over-contribute, work with your financial institution to withdraw the excess before filing taxes. Currently, in 2024-2025, the maximum the IRA has this set at is $7000 per year.
• Do I need to keep records of my child’s income for their Roth IRA?
  Yes, especially for informal jobs. Keep documentation like job descriptions, dates worked, and payment records to verify income if the IRS requests it.
• Are there penalties for early withdrawals from my child’s Roth IRA?
  Contributions can be withdrawn tax- and penalty-free at any time, but early withdrawal of earnings may incur a 10% penalty unless used for qualified expenses like education or a first-time home purchase.

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