When I say Individual Retirement Account, I imagine your first thought is retirement savings, right? I mean, after all the word “retirement” is the middle word. You wouldn’t be wrong, most of the time IRAs or Roth IRAs are used with the intent of saving money for retirement. Especially nowadays as pensions are becoming more scarce. Retirement savings are not necessarily their only purpose.
What if you used an IRA, not only to save but also to facilitate a home purchase? For an adult, this may be harder said than done for a few reasons. Growing home values, IRA contribution limits, and the priority of amassing retirement savings could make using your IRA for a home purchase difficult. You may be thinking, “I wish I thought of this earlier!”
It’s that thinking that has led some families to open a custodial Roth IRA on behalf of their child, as long as the child has “earned income.” Earned income is income from either a W-2 job or some form of self-employment. This Roth IRA would belong to the child, but until they reach the age of majority an adult must act as the IRA’s custodian.
The annual contribution limit for a Roth IRA in 2021 is $6,000. Just some food for thought, this number could change in future years. Let’s say your kid earns $5,000 from their small landscaping business or works from flipping burgers at a local restaurant. Hypothetically, they could put all $5,000 into their Roth IRA. Chances are they will want to keep some of the money they earn but depositing what they can early on could teach them a terrific lesson in compounding interest. Obviously investing involves risk, including the potential loss of principal so be sure the consult with a professional before making investment decisions.
What you will want to pay attention to is how the money is taxed when it is withdrawn from a Roth IRA. According to IRS.gov, after-tax dollars go into a Roth IRA and if the account is at least five years old, up to $10,000 of the account may be withdrawn without being taxed, as long as the amount withdrawn is used for a home purchased and the IRA owner has not bought a home in the past two years. This seems like the appropriate time to mention that before making any decision regarding withdrawals you should consult a tax professional to be sure and make an appropriate decision. One other benefit is that you take out any of your contributions without penalty. All this information can be found on IRS.gov or, like mentioned before, by working with a tax professional.
Plans change frequently, and that could apply to this as well. Once the child reaches the age of majority (either 18 or 21 depending on the state of residence) they are now the legal owner of the Roth IRA. They can choose to continue making contributions, liquidate the account, or anything in between. That makes it imperative to teach our youth about financial responsibility. (Side note about financial responsibility, every year we offer a scholarship which requires an essay for the applicants titled “What does Financial Responsibility Mean to You?”. Be sure to tell graduating seniors that you know!)
If you need some help deciding whether or not this is a strategy you want to employ, reach out to us at Redwood Financial. We can discuss whether or not it makes sense for you and your situation.
The opinions in this blog are for general information only and are not intended to provide specific financial or tax advice or recommendations for any individual.