Illustration of a hand holding a golden egg

Rather than giving a child or grandchild a gift card this holiday season, you might want to consider a gift that keeps on giving for decades: a Roth IRA.

When opening a Roth, you invest after-tax dollars rather than pretax dollars, which you’d use to fund a traditional IRA. That’s a big benefit to the beneficiary of the Roth. Under current law, the money withdrawn from Roth IRAs is 100 percent tax-free as long as long as normal withdrawal rules are followed.

“Helping a child contribute to a Roth IRA is a wonderful opportunity to invest in a child’s future and introduce that child to the value of saving,” says Bruce Berno, a certified financial planner in Cincinnati.

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Let’s say you give $500 annually over five years that is invested in a Roth IRA and the account grows at a conservative 4 percent annual rate of return. That $2,500 investment would grow to more than $16,000 in 45 years. If the account grows at an annualized 6 percent, it would be worth almost $40,000.

If you give this year’s annual IRA maximum of $5,500 for five years, the $27,500 in seed money would be worth about $175,000 in 45 years, assuming a 4 percent annualized return. At an annualized 6 percent growth rate, it would be worth more than $400,000.

If your gift encourages a child to take up the reins and save more on her own, you would have jump-started her to a secure retirement.

“The power of compounding from a young age can turn today’s investment into seven figures,” says Daniel Andersen, a certified financial planner at Parkshore Wealth Management in Roseville, Calif. “If you show a child how money grows over time, you will likely have him or her hooked.” 

What You Should Know About a Roth IRA

Before you open a Roth IRA account for a child, there are some basic things you should know. Among them:

The child needs to have earned income. The IRS is fine with parents and grandparents (and anyone else) giving someone the money to contribute to a Roth IRA. In 2019 the maximum contribution rises to $6,000.

The only catch is that the recipient must have earned income that is at least equal to the amount contributed. So if a child made $1,500 this year, you could give her $1,500 toward a Roth IRA. “Babysitting, lifeguarding, mowing lawns are fine,” Berno says. “The only rule is that it has to be earned income, not investment income.”

More on Giving and Taxes

The IRS does not require any proof, such as a W-2 form, that you have earned income, says Mark Luscombe, principal analyst at Wolters Kluwer, a tax software and information technology company. But just in case the IRS asks, it’s a good idea for your child or grandchild to keep records of the work done and the amount paid.

Unlike a tax-deductible traditional IRA, where your pretax contributions are reported on Form 1040, you don’t have to report your Roth contributions on your tax return. But if other family members want to make their own contributions, it makes sense to coordinate. “You should communicate with the child’s parents or grandparents to avoid giving more than the child’s earned income,” Luscombe says.

Giving money for a Roth IRA can be especially helpful for young adults working full-time who feel hard-pressed to save for retirement when they are juggling student loans and rent, and perhaps saving for a down payment on a house. As long as the millennial in your life has modified adjusted gross income below $120,000 this year ($189,000 for married couples filing a joint tax return), she can fund a Roth IRA up to the $5,500 annual limit. In 2019 the cutoff for a full contribution is $122,000 for individuals and $203,000 for married couples.

There won’t be a tax concern for you or the kids. In 2018, anyone can give up to $15,000 per year to an individual without triggering any gift-tax paperwork. Nor will the recipient have any tax reporting to deal with. (That limit remains the same in 2019.)

Contributing to a Roth IRA won’t have an impact on federal financial aid. When a child applies for college financial aid, the FAFSA (Free Application for Federal Student Aid) form won’t take into account money set aside for retirement regardless of whether the IRA is owned by adults or kids. But be aware that some colleges consider money saved in IRAs when calculating their aid offers and could require that a student contribute a portion of those assets to cover the costs. 

If your gift is for a minor, the parents need to open a custodial account. An adult maintains control of the account until the child turns 18 (or 21, depending on the state where the child lives). You can set up the account with the financial institution you use or check out custodial account options at low-cost brokerages including Schwab and Fidelity.

Take a long-term view when investing. Your retirement may be fast approaching, but a teenager or 20-something has decades to go. That’s an argument for investing the bulk of the money in stocks, which over the long term have delivered the best inflation-adjusted returns.

The child could decide to withdraw the money before retiring. The only real downside to gifting a Roth is that once a minor gains control of the account, there’s nothing to stop him from cashing it out. So plan to offer money lessons along with those IRA gifts.

“If you are a responsible saver, chances are your kids will follow your lead,” Andersen says. “But you also want to use your Roth IRA gifting as an opportunity to teach financial responsibility.” That’s a gift that will pay dividends for a lifetime.