Could Custodial IRAs Help Young Adults Buy Homes?
Individual retirement arrangements (IRAs) are for retirement saving, right? Absolutely. Is that their only purpose? Not necessarily.
Imagine using an IRA to save for a home purchase.
Given current home values, yearly IRA contribution limits and the priority of amassing retirement savings, this would be a tall order for an adult. How about for a child, though? Could an IRA help them out?
This thought has led some families to open custodial Roth IRAs.
You can start a Roth IRA on behalf of a child, as long as that child has earned income (income from a job in which they receive a W-2 or some kind of self-employment). The IRA belongs to the child, but until the child becomes an adult, you (or some other adult) act as the IRA’s custodian.
The annual contribution limit for a Roth IRA is $7,000 (this limit may be adjusted upward in future years due to inflation). Now, say your kid has made $4,000 from freelance web design, or serving lattes at the local coffeehouse, or working at your business. All $4,000 could go into that IRA. The amount your child accumulates may vary, of course, but whatever the amount, it may benefit from potential compounding over the next several years.
You might want to consider this as a possible use for a Roth IRA.
What about taxes that come with withdrawing money?
After-tax dollars can be contributed to Roth IRAs. Additionally, if the account is at least five years old, up to $10,000 of the account balance (including earnings) may be withdrawn without being taxed, as long as the withdrawn amount is used for a home purchase. This only applies if the IRA owner has not bought a home in the past two years. In doing this, you can avoid the 10% tax penalty that is normally associated with withdrawing assets from a Roth IRA before age 59½.
Ownership Changing Hands
When a child turns 18 (or 21, in some states), a custodial IRA started on their behalf is no longer custodial. They are now the legal owner of that IRA.
That young adult who now owns the account may elect to keep contributing to the IRA and use it as a retirement savings account. Or maybe the IRA is suddenly drained to enable the purchase of a new truck, fund a year abroad or pay for college. Choices will emerge, and parents and grandparents must be mindful of them. Also, when you withdraw assets from a tax-advantaged account, you are reducing not only the account balance, but the account’s potential degree of compounding for the future as well.
Remember that a Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59½ or prior to the account being opened for five years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Also, tax rules are constantly changing, and there is no guarantee that the tax treatment of Roth (or traditional) IRAs will remain the same.