What Is a Custodial IRA?

What Is a Custodial IRA?

Most parents worry about their children as they grow up; however, you'd think that would stop once they reach adulthood. Parents always look to set their children up for a successful future. They might be helping out with their first car, paying for higher education, or assisting them in purchasing their first home. Parents may also choose to open and operate a guardian IRA, or custodial IRA, for a child or someone who is disabled.

Understanding a Custodial IRA

Parents or legal guardians are responsible for managing a custodial IRA for their child or disabled adult. Typically, this will include the guardian signing all the legal paperwork since the other person cannot. The parent or guardian usually uses a custodial IRA to assist with setting their child up for financial success once they reach retirement age.

Even though a legal guardian manages the account, the child or disabled person still owns it. Then, once the child reaches the age of 18 or 21, depending on the state, they'll have the account transferred to them for proper handling. Disabled individuals would receive complete ownership once they can handle their finances.

There are two common types of custodial IRA accounts - Traditional and Roth.

  • A Traditional IRA will accrue money over time while remaining untaxed. However, once you reach retirement age, any money withdrawn from the account will incur an income tax.
  • A Roth IRA is the opposite. Although the account is still growing over time, the funds entering the account will suffer an income tax. However, the money you withdraw will not receive any further tax penalties.

Custodial IRA Account Benefits

One of the most important things we can do for our children is to teach them financial responsibility at a young age. Maintaining funds and establishing savings will help them apply those skills to their future finances.

People typically do not consider retirement funds until they reach their late 20s to 30s. However, by creating a custodial IRA for your kid, you'll be able to kickstart their retirement savings and help them prepare for the future.

You can withdraw money from a Traditional IRA or Roth IRA anytime. The main difference between the two accounts is how the funds are affected by taxes. A Traditional IRA will face tax penalties for an early withdrawal, while a Roth IRA does not. The ability to withdraw your funds from a Roth IRA without penalty will only assist with managing emergencies, attending college, or other money-related concerns.

Using a Custodial IRA Account

The first step when setting up a custodial IRA is choosing the right financial institution. Next, you'll need to provide general information for whomever you're opening the account with, including their social security number, employment information, annual income, and banking information.

The account is typically set up in the child's name and then funded by taxable earnings regardless of age. The funds can come from babysitting, dog walking, or a W-2 job once they reach legal age. However, the maximum limit for the account is $6,000 a year.

Takeaway

A Roth or Traditional custodial IRA is an excellent option for setting your child up for a successful retirement. However, remember the main differences between the two types of accounts. In addition, educating your children on the importance of saving money will only help them in the future when it comes to managing their finances.