The Roth Individual Retirement Account (IRA) is a popular investment vehicle, known for its tax-free growth and withdrawals in retirement. However, when it comes to opening a Roth IRA for a minor, the account becomes custodial, meaning it is managed by an adult until the child reaches adulthood. While a custodial Roth IRA can be a powerful tool for teaching kids about investing and saving for the future, it’s not without its drawbacks. Let’s explore some of the disadvantages associated with custodial Roth IRAs.
Key Disadvantages of Custodial Roth IRAs
Loss of Control Over the Account
One of the primary disadvantages of a custodial Roth IRA is that once the minor becomes an adult (18 or 25 depending on the state), control over the account must be transferred to them. This means that despite the custodian’s best efforts to teach the child about financial responsibility, there’s no guarantee that the funds will be used as originally intended. The young adult could decide to withdraw the funds for immediate use, facing no legal barriers but potentially incurring taxes and penalties if the withdrawal is not qualified.
Contribution Limits and Eligibility
Contributions to a Roth IRA are limited by earned income. For a custodial Roth IRA, this means the child must have verifiable earned income from a job or self-employment. This can be a significant barrier, as many minors have limited opportunities to earn income that qualifies. Additionally, the annual contribution limit for 2023 is $6,500 (or $7,500 for those 50 and older), which may restrict the amount of money that can be invested annually.
Impact on Financial Aid
Assets in a custodial Roth IRA are considered the child’s assets for purposes of financial aid calculations. This can adversely affect eligibility for need-based financial aid, as assets owned by the child are assessed at a higher rate than parental assets. While retirement accounts are generally not reported as assets on the Free Application for Federal Student Aid (FAFSA), distributions from an IRA (if the child decides to withdraw money for education expenses) are counted as income, which can significantly impact financial aid eligibility in the following year.
Tax Consequences and Penalties
While the Roth IRA is celebrated for its tax-free growth and withdrawals, early withdrawals that do not meet the criteria for qualified distributions are subject to taxes and penalties. For a custodial Roth IRA, this means that if the child decides to withdraw funds before age 59½ and does not meet any of the exceptions for a qualified distribution, they could face a 10% penalty on earnings in addition to being taxed at their current income tax rate.
Make an Informed Decision
A Custodial Roth IRA presents a unique opportunity to foster early financial growth and education for minors. However, it’s crucial to weigh these advantages against potential drawbacks, including loss of control, contribution limits, financial aid implications, and tax penalties. By carefully considering these factors, parents can make informed decisions that align with their child’s long-term financial well-being.
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FAQs
Even though you are not assessed a penalty on the contributions when you withdraw them, you may be assessed a penalty on the earnings like interest and dividends. Custodial Roth IRAs are not tax-deductible.
What is the disadvantage of a custodial Roth IRA? ›
Even though you are not assessed a penalty on the contributions when you withdraw them, you may be assessed a penalty on the earnings like interest and dividends. Custodial Roth IRAs are not tax-deductible.
What are the disadvantages of having a Roth IRA? ›
Earnings can't be withdrawn tax-free until age 59½ and the account is at least 5 years old. Diversification in retirement, so all of your accounts aren't tax-deferred. The maximum contribution is relatively low compared with a 401(k). You'll probably need other accounts to save enough for retirement.
Which of the following is a disadvantage of Roth IRAs? ›
There Are Income Limits
One disadvantage of the Roth IRA is that you can't contribute to one if you make too much money. The limits are based on your modified adjusted gross income (MAGI) and tax filing status.
How much money can you put in a custodial Roth IRA? ›
What is the maximum custodial Roth IRA contribution? The maximum amount you can contribute to a custodial Roth IRA is $7,000 for 2024. So even if your child earns $10,000 during the year, they can fund the Roth IRA at the max of $7,000.
What are the disadvantages of a custodial account? ›
The drawbacks: You can't change the beneficiary of a custodial account once it's established. Your child can use the money however they want after reaching a certain age, and investment income in custodial accounts may trigger the kiddie tax.
When can you take money out of a custodial Roth IRA? ›
Unlike many tax-advantaged retirement accounts, you can access the money in a Roth IRA early. Though your child's investment earnings will still be subject to withdrawal restrictions, the original contributions can be withdrawn at any time tax-free and penalty-free.
At what point is a Roth IRA not worth it? ›
The tax argument for contributing to a Roth can easily turn upside down if you happen to be in your peak earning years. If you're now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down.
At what age should you not do a Roth IRA? ›
There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.
How do I avoid taxes with a Roth IRA? ›
Roth IRA taxes on earnings
To withdraw your investment earnings without paying taxes on them, you need to have had the account open for at least five years and be at least age 59 ½. Otherwise, you'll face a fairly steep 10% penalty, plus income tax, on what you withdraw (though there are some exceptions).
Money that you'll need soon isn't a good candidate for conversion because your assets may not have time to recoup the taxes you would have to pay. You're currently receiving Social Security or Medicare benefits.
What are the limitations on Roth IRAs? ›
Roth IRA contribution limits for 2024
The Roth IRA contribution limit for 2024 is $7,000 for those under 50, and an additional $1,000 catch up contribution for those 50 and older. Source: "401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000," Internal Revenue Service, November 1, 2023.
Who Cannot use a Roth IRA? ›
However, not everyone is eligible to contribute to a Roth IRA. In 2023, single filers with adjusted gross incomes (MAGIs) of $153,000 or more cannot contribute to a Roth IRA, while those who are married and file jointly become ineligible once their MAGI reaches $228,000.
What are the cons of a custodial Roth IRA? ›
Key Disadvantages of Custodial Roth IRAs
- Loss of Control Over the Account. ...
- Contribution Limits and Eligibility. ...
- Impact on Financial Aid. ...
- Tax Consequences and Penalties.
After the Roth IRA has been funded for five years, your child can take out up to $10,000 in earnings to buy a first home, tax- and penalty-free. Roth IRA earnings can be used for qualified education expenses, such as college tuition. Earnings distributed will be taxed as income, but there will be no penalty.
What is the difference between a Roth IRA and a custodial Roth IRA? ›
For the most part, a custodial Roth IRA operates in the same way as a regular Roth IRA. There is one main difference between these two types of accounts: Because custodial Roth IRAs involve minors, they need to have a parent (or another adult) assigned as a custodian.
What happens to a custodial Roth IRA when the child turns 18? ›
While your child is still under age 18, the custodian will need to manage the account's assets. But when your child reaches the legal age in your state (usually 18 or 21), the custodial Roth IRA will need to be converted to a regular Roth IRA in their name.
Who should not do a Roth IRA? ›
The tax argument for contributing to a Roth can easily turn upside down if you happen to be in your peak earning years. If you're now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down.
Can a parent contribute to a child's Roth IRA? ›
Yes. Direct contributions to a child's Roth IRA can be a gift from you or someone else. 12 And they truly are gifts that keep on giving. Since Roth IRAs can be invested in almost any sort of asset, they are likely to perform much better than a good old savings bond or bank account.
