What Is a Custodial IRA?

A custodial individual retirement account (IRA) is an IRA managed by a parent or guardian for the benefit of a minor child, as long as that child works and has earned income.

A custodial IRA can be either a traditional IRA or a Roth IRA. As with other types of IRAs, the maximum annual contribution for 2016 is $5,500 (indexed annually for inflation) and the underlying investments can be determined by the person managing the account, in this case the parent or guardian, prior to the child reaching majority age.

Although an adult typically oversees the account, the funds belong to the minor child and must be turned over at the age of majority, which varies depending on the state. IRAs present tax benefits, and opening an account when a child is relatively young may enhance these advantages. As long as the money remains invested, contributions and investment earnings may potentially compound free of taxation. The longer the time period when contributions are made and the money can compound, the greater is the opportunity to build wealth. Required minimum distributions (RMDs) from traditional IRAs, which are taxed as ordinary income, are mandatory after age 70½. For Roth IRAs, RMDs are not required, and the assets could potentially compound for a lifetime. Restrictions, penalties, and taxes may apply. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.

Withdrawals

The objective of an IRA is to invest for retirement, but IRS rules may permit penalty-free withdrawals for higher education expenses, a first-time home purchase, and other reasons. If your child has a custodial IRA, theoretically he or she could make withdrawals to help further these financial goals without paying a 10% early withdrawal tax. The amount of the withdrawal, however, may be subject to ordinary income taxes unless certain qualifications are met. See IRS Publication 590-B for additional information.

It's important to understand that assets within a custodial IRA are considered an irrevocable gift and become the property of the child. A parent or guardian cannot reclaim the assets once the account has been established. Since the assets do belong to the child, the parent or guardian has no control over the child's ability to take non-qualified withdrawals once the child reaches the age of majority.

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