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Why a Custodial Account Is a Smart Choice for Your Child’s Financial Security

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Opening a custodial account for a child is a smart financial decision that can have many benefits. A custodial account is a type of investment account that allows parents or other adults to invest on behalf of a minor child, who is the beneficiary of the account. This type of account offers many advantages, including the ability to save for the child’s future, teach them about money and investing, and potentially earn tax benefits. In this age of increasing financial uncertainty, opening a custodial account for a child can provide a solid foundation for their financial future. There are also some nuances to be aware of such as potentially impacting future college financial aid and the kiddie tax. In the following paragraphs, we will explore the benefits of a custodial account for a child in more detail.

Custodial Accounts Can Build a Solid Financial Foundation Early

There are many benefits to a custodial account including that it enables a child to build a solid financial foundation early. Instead of family and friends always buying toys, a custodial account enables them to gift money that can be used to buy stocks, ETFs, mutual funds and bonds. Over time this money compounds and can help a child have money to pay for large expenses as the enter adulthood like college, a first car, a first and last payment for their first apartment and more.

Custodial Accounts Teach Children about Money and Investing

A custodial account enables a child to learn about money and investing at an early age. They can be involved in investing decisions as appropriate such as using the money to buy shares in their favorite companies such as Disney. A child can also witness passive income at an early age by seeing their account get dividend payouts. They can also start learning about retirement tools at an early age like Roth IRAs.

Adult Retains Control of The Custodial Account

The account custodian, whether a parent or another adult, has control over the account until the child reaches a certain age. Depending on the state, the custodian will have control either until the child is 18 or 21. The custodian has control to make investment decisions, and can decide how much they want the child to be involved in the investment decisions.

Once the child becomes of age, the funds in the custodial account are legally theirs to control and use as they see fit.

Potential Tax Savings By Opening a Custodial Account

Though a child could end up owing taxes and/or being taxed at the parents’ rate if they make enough unearned income, a custodial account is still a potential way to save money on taxes. If a minor child exceeded the $2,300 annual limit in 2022, they would be taxed at the parents’ tax rate. However, the first $1,150 of unearned income is covered by the kiddie tax’s standard deduction. Therefore, a child would not pay taxes on this first amount. A child who makes $1,150- $2,300 in unearned income like dividends in 2022 will have to file a tax return and will be taxed at the child’s marginal tax rate. Only any amount above $2,300 will be taxed at the parents’ marginal tax rate.

What is the Kiddie Tax?

Before a custodial account is opened for a child, it’s important to become familiar with the kiddie tax. The kiddie tax is a law passed in the US to discourage wealthier individuals from transferring assets to their children to take advantage of their lower tax rates. Current rules tax a minor child’s unearned income like capital gains distributions, dividends and interest incomes at the parents; tax rate if their unearned income exceeds the annual limit. The annual limit in 2022 was $2,300.

The kiddie tax applies to dependent children under the age of 18 and full-time students younger than 24. Learn more about how children are taxed for their unearned income as well as how earned income can impact the taxes they pay see IRS Publication 929 and/or consult your tax advisor.

Custodial Accounts Have Potential Impacts to Financial Aid for College

Even though the custodian retains control of the account until the child is 18 or 21 depending on the state, colleges consider these accounts to be owned by the child. Since the custodial account is considered owned by the child, it could negatively impact the financial aid package from colleges.

Benefits of a Custodial Account for a Child Summary

In summary, there are many benefits of a custodial account for a child. Not only does it allow parents or other adults to save for the child’s future, but it also provides an opportunity to teach them about money management and investing. Additionally, a custodial account can potentially save money on taxes, which can help maximize the amount of money available for the child’s future needs. By starting early and making regular contributions, a custodial account can provide a solid foundation for a child’s financial future and help them build a healthy relationship with money. Overall, a custodial account is a valuable tool for any parent or guardian who wants to ensure their child’s financial well-being.

2023 Roth IRA Rules: What You Need to Know

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Roth IRA Rules in 2023

A Roth IRA is a type of individual retirement account that allows for tax-free withdrawals in retirement in the United States. In 2023, the contribution limit for a Roth IRA is $6,500 for those under the age of 50 and $7,500 for those 50 and over. There are many benefits to having a Roth IRA including no minimum distribution and no taxes on any gains. Contributions to a Roth IRA are made with after-tax dollars and qualified withdrawals, including earnings, are tax-free. There are income limitations for contributing to a Roth IRA, and early withdrawals may be subject to taxes and penalties. It’s important to understand Roth IRA rules and requirements in order to make informed decisions about saving for retirement.

What Is A Roth IRA

A Roth IRA is a retirement account that offers you a tax benefit when you retire. Unlike traditional IRAs and 401(k) plans Roth IRA contributions are not tax deductible but you also do not pay taxes when you withdraw money at age 59 ½ +.

Roth IRA Contribution Limits 2023

The 2023 Roth IRA contribution limit is $6,500 for the year. If you’re 50 or older you can contribute up to $7,500 for the year. These contribution limits increased by $500 compared to 2022. So, if you haven’t contributed to your Roth IRA in 2022 yet, you can still contribute up to $6,000 or $7,000 if you’re 50 or older before April 15th. The amount you contribute also cannot exceed what the IRA defines as “earned income” or taxable compensation. This includes wages, salaries, tips, commissions, professional fees and self-employment income. Charles Schwab shares more details here on what’s considered earned income for a Roth IRA.

The amount you contribute to a 401(k) plan does not impact the amount you can contribute to a Roth IRA but the amount you contribute to a Traditional IRA will affect the amount you can contribute to a Roth IRA. If you contribute to both a IRA and Roth IRA in the same year, the total contributions to both of these accounts cannot exceed $6,500 if you’re under 50, or $7,500 if you’re 50 or older.

Setting Up A Roth IRA For A Child

You can also set up a custodial Roth IRA for your child, subject to the same contribution limits outlined above. This means that contributions for your child’s Roth IRA you control cannot exceed what your child earned in 2023.

Roth IRA Income Limits 2023

There are income limits on Roth IRA eligibility which is why it’s important to start your contributions to a Roth IRA the first year you get a W-2. If you are single, and your modified AGI is $138,000 the amount you can contribute to a Roth IRA begins to phase out. You cannot contribute to a Roth IRA in 2023 as a single filer if you make more than $153,000.

If you are married filing jointly and your AGI is $218,000 or above the amount you’re eligible to contribute begins phasing out. If you are married filing jointly you cannot contribute to a Roth IRA if you make more than $228,000 in 2023. Once you exceed this income you will need to explore options to setup a backdoor Roth IRA if you’re interested in having a Roth IRA. To take full advantage of a Roth IRA, set up a Roth IRA when you first start collecting a paycheck. You never know when you may get to the point where your income makes you ineligible to contribute to a Roth IRA.

Here are the contribution limits by income and filing status for a Roth IRA in 2023:

roth ira rules 2023, roth ira 2023 contribution limit
Source: IRS

When Can You Contribute to a Roth IRA

Contributions to a Roth IRA can occur at anytime during the year. You may contribute the full amount all at once or contribute multiple times during the year up to the maximum. Once a new calendar year starts, you can still make contributions for the previous calendar year up until April 15th (when taxes are due). For example, you can make a contribution for 2022 to your Roth IRA until April 15, 2023.

Roth IRA Withdrawals

Since you’ve already paid taxes on your contributions, you can withdraw your contributions at any time with no restrictions. If you withdraw earnings on those contributions though, you may be taxed or penalized on withdrawing this money.

Roth IRA rules dictate that once you’re age 59 ½, as long as you’ve held the account for at least five years, you can take distributions on all money within the account and do not have to pay taxes on that money.

Roth IRA Minimum Required Distribution

With a Roth IRA there is no required minimum distribution. You don’t ever have to withdraw from this account if you don’t need to. Additionally, you can pass this money onto your heirs.

Unlocking the Potential of the Mega Backdoor Roth 401(k): A Comprehensive Overview

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what is a mega backdoor roth 401k, how to get a mega backdoor roth 401k

A mega backdoor Roth 401(k) is a good tool for high-income individuals to save more money for retirement and reduce future taxes. It is called a “backdoor” Roth 401(k) because it allows individuals to contribute above the 401(k) limit – which is $22,500 in 2023. Through a mega backdoor Roth 401(k) you can contribute up to $66,000 in 2023 if you’re under 50 years of age. There are some important considerations to keep in mind when using this strategy. This includes whether or not the plan includes automatic conversions. Learn if this strategy of using a mega backdoor Roth 401(k) is right for you.

What is a Mega backdoor Roth 401(k)

A mega backdoor Roth 401(k) is a way to contribute additional funds to a 401(k). It involves making after-tax contributions to your 401(k) through your employer. It is a useful tool for high earners who want to take advantage of tax-free growth and the withdrawal benefits of a Roth retirement account and have already maxed out the pre-tax maximum of their 401(k). Because the tax is paid prior to the contribution, any earnings are tax free. These tax savings can really add up the earlier you leverage this tax strategy in your career.

How Much Can You Contribute to a Mega Backdoor Roth 401(k)

Every year, the IRS sets the employee pre-tax and Roth 401(k) contribution limits. The maximum combined amount you and your employer can put into a 401(k) in 2023 is $66,000 for under age 50. For over age 50, the maximum is $73,500 in 2023.

Does Your Mega Backdoor Roth 401(k) Plan Offer Automatic Conversions

When signing up for the mega backdoor Roth 401(k) through your employer, it is important to understand if the plan supports automatic conversions. This means that once new contributions are made to your after-tax account they are immediately converted to your Roth account. Though the contributions have already been taxed, any earnings from the contributions haven’t been taxed. An automatic conversion can reduce your tax liability on each conversion. This is because it eliminates the time the incoming money would be accruing taxable earnings. If your company does not offer this, you may have to do it manually and it could result in higher taxes. Converting any earnings to a Roth will trigger a tax bill in the year of the conversion. So, if you have to do a manual conversion you’ll want to do it the same day the contribution is made.

When Can You Start Withdrawing From a Roth 401(k)

As of 2023, the earliest you can withdraw from your 401(k) is 59 ½ years old without incurring a penalty. There are some exceptions to this rule. You may be able to take penalty-free withdrawals of your contributions at any time, as long as you held the account for at least 5 years. You can also withdraw 401(k) earnings if you meet these exceptions:

  • You become disabled
  • The funds are used for certain qualified higher education expenses
  • The funds are used to buy a first home (up to $10,000 lifetime limit)
  • The funds are used to pay for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
  • You use the funds to pay for health insurance premiums while you are receiving unemployment benefits

Laws do change, so it is always best to consult your accountant before you make any withdrawals of your Roth 401(k). These also are available for Roth 401(k) accounts and may not apply to other types of retirement accounts. If you do withdraw early, even following these exceptions, you will lose out on tax free future earnings.

Should You Contribute the Full Amount to a Mega Backdoor Roth 401(k)

Ultimately, how much you contribute to a Mega Backdoor Roth 401(k) depends on your situation. You may want to stay more liquid in your taxable accounts given the current economic uncertainty. Your 401(k) plan may not offer as many investment options as your Roth IRA. The tax savings now with a pre-tax 401(k) may also be more impactful than the tax savings realized 30 years from now. Or, you may have better investments available outside your 401(k) which outweigh any future tax savings. As you start earning more money though, your financial plans should be reassessed. It is a great time to consider to if the Mega Backdoor Roth 401(k) should be part of your retirement savings strategy.