THE BLOG

Starting Roth IRAs for Your Grandkids

02/18/2015 04:40 pm ET | Updated Apr 20, 2015

Grandparents are notorious for spoiling their grandkids, but sometimes a more strategic approach to giving money can provide grandchildren a much better financial start.

A 2012 MetLife Mature Market Institute study reported that 62 percent of grandparents provided financial support or monetary gifts for their grandchildren. In light of the recent economic downturn, some have indicated increased pressure to help out, says the study.

If you're seeking to contribute to your grandkids' financial future, there are many options. One is to open a custodial Roth IRA on behalf of your grandchild as soon as the grandchild starts reporting earned income. Custodial Roth IRAs may allow for more flexibility than a 529 college savings plan, which many believe advantageous for their personal estate planning as well as supporting their grandchild's educational future.

Though retirement accounts are best used as retirement vehicles only, the tax-free withdrawal advantage of a Roth IRA makes it a useful savings tool for other needs young adults have, such as additional education expenses not covered by savings or a down payment on a first home.

Unlike traditional IRAs, Roth IRAs are funded with after-tax dollars. That means the account holder doesn't get a tax break at the time of initial or successive deposits, but the money grows tax-free and can be withdrawn tax-free - a benefit for a grandchild who may need a substantial sum in the years to come. Learn more about Roth IRAs by watching this Khan Academy video.

Here's an example of how much an initial $2,000 deposit in a Roth custodial IRA can grow. For an account opened at the time the child is 16, the $2,000 opening deposit - without any more money added to the account - could be worth roughly $55,000 at the time the child reaches age 65, assuming a 7-percent expected rate of return.

What if the child needs to make a tax-free withdrawal sooner, such as at age 35, for example? Based on the same earnings calculation as above, he or she would receive a less-impressive sum of roughly $7,200. Of course, it remains a potential solution if there is a severe need for cash.

In 2015, the annual contribution limit for all IRAs is $5,500. It's not that easy for a minor to open a Roth IRA on his or her own, which is why it's good for grandparents - or any qualifying friend or relative - to shop for custodial accounts with low fees and low investment minimums to start.

Custodial accounts also present grandparents with a teachable moment to educate their grandchildren about the importance of managing finances. Grandparents can encourage their grandchildren to use their own income to make deposits to the account over time and encourage an ongoing discussion about how the grandchild will handle the account after it is put in their name.

As you evaluate a decision to open a custodial Roth IRA, check with the broker and the account administrator on any institutional or state rules on custodial accounts. Depending on those rules, there's a chance that grandparents may not be able to open the custodial account directly and will have to work through parents or legal guardians to get started.

To open the account, you will need the grandchild's name, address, date of birth and Social Security number, in addition to their earned income.

You should also consider the following:

Make sure you are financially secure. The MetLife study notes that many grandparents tend to overextend their financial support when it comes to family members in need. Get advice from financial, tax and estate professionals on how much you can reasonably afford to give and the best means to do so.

Coordinate with your grandchild's parents or guardian. It is important for family members to remain open about all money issues, particularly in relation to minors. Discuss what provisions the parents have made for the child and whether your idea complements financial strategies already in place. If not, keep talking and discuss other ways you can potentially help.

Consider your grandchild's potential handling of the account. When your grandchildren reach age 18 or meet other key requirements of the account, they can take control of the money. Will they be ready? If you have your heart set on a specific purpose for that money to help them, you should examine whether you might want to choose another investment vehicle that better meets your objectives.

Bottom line: Setting up a custodial Roth IRA may be a good way for grandparents to set their grandchildren on a solid path toward retirement or intermediate financial goals.

Jason Alderman directs Visa's financial education programs. To follow Practical Money Skills on Twitter, visit twitter.com/PracticalMoney.

Top 8 Benefits of Financial Education