When children come into money, it’s often earned from household chores, babysitting, or a part-time job. However, children may also earn income from acting or modeling gigs, a monetized social media channel, or inherit money from a family member. Regardless of how a child obtains money, in most cases, a parent will have to act as a custodian until the child reaches the age of majority, which is usually 18 but can be 21 in some areas.
While banks may allow a minor to have a checking or savings account with an adult cosigner, children cannot own stocks or mutual funds unless a custodial account is used. All assets in a custodial account are held in the child’s name and must be turned over to the child when they reach the age of majority. Any funds used before the age of majority must benefit the minor.
When children have earned income, we generally recommend opening a custodial Roth IRA. Over 50 years, the investment could grow into a fairly sizeable retirement fund. The IRA contribution must be the lesser of $7,000 (in 2024) or 100% of wages earned. So, if the child only makes $1,000 a year from mowing lawns, the total IRA contribution is limited to $1,000.
It’s not uncommon for parents to open a savings account for a young child who is earning or receiving money. Once the account reaches a substantial amount, the bank may recommend the parents invest the money in CDs or mutual funds. We’ve seen this more than once, where something that started out small turned into a substantial amount by the time the child was in their teens. Because the account was set up as a custodial account, parents may soon realize that at 18, their child will have access to tens or hundreds of thousands of dollars.
If this is the case, there are steps a parent can take as custodian to set their child up for financial success. If the goal of the money is to pay for the child’s education, parents may consider taking cash out of the child’s account and reinvesting it in a 529 Plan for the benefit of the same minor. This would allow the funds to continue to grow tax free. Withdrawals used to pay for qualified education expenses are also federal income tax free. The benefit of this move is that a 529 Plan is considered a parent-owned asset, which has considerably less impact on the Free Application for Federal Student Aid than student-owned assets.
If parents want to protect some of the child’s assets for retirement, they could remove assets from the custodial account and contribute them to a Roth IRA once the child has earned income. For example, say a child earned money as a toddler and it was invested in a custodial brokerage account. Over the past 15 years, the account has experienced substantial growth. Now that the child is 16 and has a part-time job, the parents can withdraw cash from the custodial account, likely paying only capital gains tax. The parents can then reinvest the money into a Roth IRA for the child, which provides tax-free growth and tax-free withdrawals in retirement.
A trusted financial adviser can provide guidance and help manage a child’s money so that it can benefit the child in the long term. Parents then can hopefully avoid having their 18-year-old spend their sudden wealth frivolously.
If you have questions on how to set up custodial accounts or Roth IRAs for your children, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the June 29, 2024 “Henssler Money Talks” episode.
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