How Roth IRAs Create Tax-Free Retirement Savings for Kids | Mora

Giving your child a financial advantage begins with smart decisions today. Roth IRAs are the ultimate tool for creating tax-free retirement savings for kids, offering unmatched growth, flexibility, and tax advantages. With decades of compounding potential, you can ensure your child’s retirement is secure and stress-free.

In this guide, we’ll show you:

• Understanding Custodial Roth IRAs
• The Power of Tax-Free Retirement Savings for Kids
• Why Starting Early Maximizes Growth
• How To Set Up Tax-Free Retirement Savings for Your Child

‍

Understanding a Custodial Roth IRA

A Custodial Roth IRA is a retirement savings account set up and managed by a parent or guardian on behalf of a child. It’s designed to provide kids with a head start in building tax-free retirement savings.

Here’s how it works:

• Earned Income Requirement: Your child must have taxable earned income to qualify for a Custodial Roth IRA. This can include wages from part-time jobs, babysitting, or self-employment. Allowances or gifts do not count.
• Parent as Custodian: As the custodian, you manage the account until your child reaches the age of majority (typically 18 or 21, depending on your state). You control contributions, investments, and withdrawals on their behalf.
• Transfer of Control: Once your child becomes an adult (18 or 21 depending on your state), the account transitions to their full ownership. They can manage investments, make contributions, and withdraw funds independently.
• Tax-Free Advantages: Contributions are made with after-tax dollars, so there’s no immediate tax deduction. However, all growth and qualified withdrawals are completely tax-free, making this a powerful tool for long-term savings.

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

The Power of Tax-Free Retirement Savings for Kids

A Roth IRA is one of the most effective ways to secure tax-free retirement savings for kids. Unlike other accounts that may require paying taxes on earnings, Roth IRAs allow every dollar to grow tax-free - and withdrawals are tax-free in retirement. Here’s how this works:

Tax-Free Growth and Withdrawals in Retirement

A Roth IRA is the ultimate tool for creating wealth that your child keeps - tax-free. Unlike a brokerage account, where up to 50% of earnings can be lost to taxes, a Roth IRA ensures all growth stays untouched by the IRS.

Here’s how it works:

• Contributions Are After-Tax: You pay taxes upfront, so there’s no deduction now.
• Earnings Grow Tax-Free: All gains in the account compound year after year without ever being taxed.‍
• Withdrawals Are Tax-Free: After age 59½, your child can withdraw both contributions and earnings without paying a cent in taxes.

Tax Implications of Withdrawals Before Retirement

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 need to know:

• Roth IRAs offer unmatched flexibility, making them an essential tool for your child’s financial future. Here’s how withdrawals work:
  
  • Contributions: Contributions can be withdrawn anytime, completely tax- and penalty-free. Because these funds are made with after-tax dollars, they’re always yours to access.
  • Qualified Withdrawals (Earnings): After 5 years, your child’s earnings can be withdrawn tax- and penalty-free if one of the following conditions is met:
    • The account holder is 59½ or older.
    • Funds are used for a first-time home purchase (up to $10,000 lifetime).
    • The account holder becomes disabled.
    • The account holder passes away, and the funds are distributed to beneficiaries.
  • Early Withdrawals of Earnings: Withdrawing earnings early may incur taxes and a 10% penalty unless specific exceptions apply.
  Penalty-Free Exceptions for Early Withdrawals: Even if the 5-year rule isn’t met, your child can avoid the 10% penalty under these conditions:
  • Education expenses: Qualified higher education costs for themselves, a spouse, or family members.
  • Medical expenses: Unreimbursed expenses exceeding 7.5% of adjusted gross income.
  • Health insurance premiums: If unemployed and eligible.
  • Birth or adoption expenses: Up to $5,000 within a year of the event.
  • IRS levy: If the IRS places a levy on the account.
• Order of Withdrawals: Withdrawals from a Roth IRA follow a specific order to maximize tax efficiency:
  • Contributions: Always withdrawn first, completely tax- and penalty-free.
  • Conversions (e.g. converted funds from a traditional IRA or another eligible retirement account into your Roth IRA): Withdrawn second; if withdrawn before 5 years, conversions may incur a penalty (though not taxes).
  • Earnings: Withdrawn last, subject to taxes and penalties unless qualified.

Flexibility for Life Events

One of the most versatile features of a Custodial Roth IRA is its flexibility in accessing funds. Contributions in a Roth IRA can be accessed anytime, tax-free and penalty-free - ideal for unexpected needs or big life milestones.

After 5 years, certain situations also allow for penalty-free withdrawals of earnings. While taxes may still apply, the following conditions allow you to avoid the 10% early withdrawal penalty:

Education Expenses

Your child can withdraw contributions at any time, tax- and penalty-free, to cover qualified education expenses. After five years, even earnings can be tapped for college or training costs without a penalty. This means access to funds for school without adding to student debt-an advantage that can set them up for success early on.

First-Time Home Purchase

The Roth IRA allows a tax- and penalty-free withdrawal of up to $10,000 in earnings for a first-time home purchase. When your child is ready to buy a home, they’ll have access to funds for a down payment, supporting financial independence while keeping long-term growth on track.

Health and Medical Expenses

In times of health or employment challenges, a Roth IRA allows penalty-free withdrawals for unreimbursed medical expenses or health insurance premiums during unemployment. This support protects their savings and helps them stay focused on health when it matters most.

Freedom from Required Minimum Distributions (RMDs)

Unlike a Custodial Traditional IRA, which requires withdrawals starting at age 73, a Roth IRA has no RMDs, allowing funds to grow tax-free indefinitely. This means your child’s savings can continue building wealth, free from mandatory withdrawals.

Why Starting Early Maximizes Growth

Starting early means small contributions today can grow into significant wealth by retirement age. Time is the most valuable ingredient in building tax-free retirement savings.

Compound Interest in Action

A Roth IRA capitalizes on the power of compound interest over a long timeline. By investing early, a child’s Roth IRA contributions have decades to grow, creating significant wealth by the time they reach retirement.

For instance, starting a Custodial Roth IRA at age 3 with $6,995 added annually at a 7% return could grow to around $7.9 million by age 59. Delaying until age 15 reduces this to $2.9 million - a loss of $5 million due to the delayed start.

Other accounts, like 529 Plans or Custodial Brokerage Accounts, offer less advantage in terms of tax-free compounding or come with limitations on spending.

‍Use Mora’s Wealth Calculator to visualize the long-term benefits of starting early.

How To Set up a Custodial Roth IRA

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 (see the full list in our in-depth guide).
• 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’. 

Mistakes to Avoid When Creating Tax-Free Retirement Savings for Kids

Even with the best intentions, common errors can derail your efforts. Avoid these pitfalls:

• Skipping Documentation: Always verify your child’s earned income with proper records.
• Over-Contributing: Contributions can’t exceed the child’s income; doing so leads to penalties.
• Ignoring Custodial Responsibilities: As the custodian, you must manage the funds solely for your child’s benefit until they reach adulthood.

Read our guide on ‘6 Mistakes To Avoid When Setting Up Your Child’s Roth IRA’.

How Mora Simplifies Setting Up a Roth IRA for Kids

At Mora, we believe every child deserves a strong financial foundation. Our process makes setting up a Custodial Roth IRA effortless.

From ensuring compliance with IRS guidelines to offering expert advice on investment strategies, we handle the details so you can focus on what matters most—your child’s future.With Mora’s personalized support, you’ll feel confident knowing you’re building a legacy of financial security.

FAQs About Tax-Free Retirement Savings for Kids

• How does a Roth IRA provide tax-free retirement savings for kids?
  Roth IRAs allow after-tax contributions to grow tax-free, and qualified withdrawals are also tax-free, creating a lifetime of tax-free savings.
• Can I contribute to my child’s Roth IRA if they don’t have earned income?
  No, contributions must come from taxable earned income like wages from a job or self-employment.
• Are withdrawals really tax-free?
  Contributions are always tax-free to withdraw. Earnings are tax-free after age 59½ or for qualified expenses like education or a first-time home purchase.

‍