Setting the stage for a secure financial future is an essential aspect of life, and starting early can yield substantial rewards. While traditional investment vehicles may seem out of reach for minors, the Roth IRA provides an excellent opportunity for young individuals to lay the groundwork for long-term financial growth. In this article, we will explore the steps and options available to minors looking to fund a Roth IRA and understanding when filing taxes will be necessary.

Understanding Roth IRAs

A Roth Individual Retirement Account (IRA) is a tax-advantaged retirement savings vehicle that allows individuals to contribute after-tax money, meaning you don’t receive an immediate tax deduction for contributions. However, the funds in a Roth IRA grow tax-free, and withdrawals in retirement are tax-free as well, provided certain conditions are met.

Eligibility Criteria

To open and fund a Roth IRA, certain eligibility criteria must be met. In the case of minors, the requirements are slightly different compared to adults:

  1. Age Requirement: The minor must have earned income to contribute to a Roth IRA. Earned income includes wages, salaries, tips, and other taxable compensation, but not unearned income like allowances or gifts. There is no minimum age for earning income, so even teenagers with part-time jobs or self-employed ventures can qualify.
  2. Legal Age of Consent: Minors cannot enter into financial contracts on their own, including opening investment accounts like Roth IRAs. However, some states allow minors to enter into contracts with parental or guardian consent. If this option is not available, the parent or guardian may have to open a custodial Roth IRA on behalf of the minor.

Custodial Roth IRA

A custodial Roth IRA, also known as a custodial account, is a legal structure that allows a minor to hold and manage investments with the assistance of a parent or legal guardian as the custodian. The custodian controls the account until the minor reaches the age of majority, which is typically 18 or 21, depending on the state and account rules.

Earned Income & Taxation

The key to contributing to a Roth IRA is the earned income.  While this can be accomplished through a part-time job, internship, or other traditional method of income, it can also be much simpler such as lawn care (personal favorite!), snow shoveling or other general chores and odds jobs.

Once earned income is achieved, a minor can allocate their income into a Roth IRA assuming their earnings are under the income limitations of $153,000 in 2023.  The contribution limits for this year is $6,500.

Tax Filing

In the United States, whether a minor must file a tax return depends on the amount and type of earned income they receive, as well as their overall tax situation. Here are some guidelines to determine if a minor needs to file a tax return:

  1. Earned Income Threshold: If a minor’s earned income (income from working) exceeds the standard deduction for the tax year, they are generally required to file a tax return. The standard deduction is the amount of income that is not subject to federal income tax.  The standard deduction for a single taxpayer is $13,850.
  2. Unearned Income: Minors may also have unearned income, such as interest, dividends, or capital gains from investments. In certain circumstances, unearned income can be subject to the “kiddie tax” rules, which may require filing a separate tax return for the minor.
  3. Self-Employment Tax: If a minor is self-employed and earns more than $400 in net income from self-employment, they are required to file a tax return to report and pay self-employment taxes.
  4. Tax Withheld: If the minor had federal income tax withheld from their paychecks, they might need to file a return to get a refund of the taxes withheld.
  5. Other Special Cases: There may be other situations, credits, or deductions that could require a minor to file a tax return. For example, if they qualify for certain refundable tax credits like the Earned Income Tax Credit (EITC), they may need to file a return to claim the credit.

It’s important to note that even if a minor is not required to file a tax return, they might still choose to do so. Filing a return could allow them to claim a refund if they had federal income tax withheld from their pay, or if they qualify for certain tax credits.

Parents or guardians should consider seeking advice from a tax professional or using tax preparation software to determine the minor’s tax filing requirements accurately. Additionally, tax laws can change, so it’s essential to consult the most up-to-date information from the Internal Revenue Service (IRS) or a tax expert.

Presented by the Financial Planning Committee of Lake Street, an SEC Registered Investment Adviser

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Investing involves risk and you may incur a profit or a loss.