Growth Starts Early with Custodial Self-Directed IRAs

When it comes to saving for the future, what’s the number one thing you always hear? “I wish I had started sooner.” So why not give your kids a head start on saving as early as possible? A Custodial Self-Directed IRA can help grow your child’s savings in a tax-sheltered environment, ensuring greater growth for their future. Whether you’re tired of lower-yield bonds, navigating the volatility of the stock market, or looking to kick-start your child’s financial journey, this blog offers insights into how Custodial Self-Directed IRAs can serve as a powerful tool.

First, Let’s Understand Custodial IRAs

A Custodial IRA is a retirement account set up by a parent or guardian for a minor, allowing the child to begin saving for retirement at an early age. To be eligible to contribute, the minor must have earned income from self-employment or a job. While the parent or guardian is responsible for managing the account and assets until the minor reaches the age of majority, the IRA custodian holds custody of the IRA.

The parent or guardian manages the account until the minor reaches the age of majority, which is usually 18, though some states extend this age up to 25. At that point, control of the account and its assets is transferred to the minor, allowing them to take full responsibility for managing the IRA. When setting up a Custodial IRA, you can choose between a traditional or Roth IRA, each offering distinct tax advantages.

What’s the difference between a Custodial Roth IRA and a Custodial Traditional IRA?

While a Custodial Roth IRA is often the more popular choice, both options offer unique benefits. A Custodial Traditional IRA allows for tax deferral, meaning you won’t pay taxes on the contributions or earnings until funds are withdrawn in retirement. Contributions may also be tax-deductible, though for most minors, whose income is typically lower, these deductions may not provide significant tax benefits.

On the other hand, a Custodial Roth IRA provides a tax-free growth environment. While contributions to a Custodial Roth IRA are made with after-tax dollars (meaning they’re not tax-deductible), the earnings grow tax-free, and qualified withdrawals in retirement are not taxed. Although contributions are not tax-deductible, the long-term tax-free growth often makes a Custodial Roth IRA a more favorable option for building wealth over time.

It's always a good idea to consult with a financial advisor or tax professional to determine which type of Custodial IRA best suits your child’s future.

What does the “Self-Directed” in Custodial Self-Directed IRA mean?

When you set up a standard Custodial IRA for your child, you'll open an account with a traditional IRA custodian, such as Charles Schwab or Fidelity. These financial institutions safeguard the funds and ensure compliance with IRS regulations. With a standard Custodial IRA, your investment options are typically limited to stocks, bonds, and mutual funds, which often offer lower yields or rely on the performance of the stock market.

A Self-Directed IRA custodian, like Preferred Trust Company, provides more flexibility by allowing you to open a Custodial Self-Directed IRA. With a Custodial Self-Directed IRA, you can invest in a broader range of alternative assets, beyond just stocks, bonds, and mutual funds. These alternative investments can include real estate, precious metals, agriculture, and even digital currency. The term "self-directed" refers to the fact that you have the ability to make investment decisions and directly manage the investments within the account.

It's important to conduct thorough due diligence before making any investment decisions to ensure you're making informed choices for your child's future.

What are the requirements for a Custodial Self-Directed IRA?

Before setting up a Custodial Self-Directed IRA, there are some important requirements and limits to keep in mind:

Do you have to wait until retirement to access the funds?

Usually, an IRA doesn’t allow for withdrawals until retirement without a penalty. Custodial IRAs have a couple of specialty rules when it comes to withdrawals:

• Contributions can be withdrawn penalty-free at any time. However, for a Traditional IRA, contributions may be subject to income tax when withdrawn. For a Roth IRA, contributions are withdrawn tax- and penalty-free because they were made with after-tax dollars.
• Withdrawals of any earnings are subject to tax and penalties before the age of 59 ½ unless exceptions apply.
• Earnings can be withdrawn penalty-free for qualified higher education expenses or a first-time home purchase (up to $10,000) for Roth IRAs. However, if the Roth IRA has not been open for at least 5 years, the earnings will be subject to taxes and a penalty. For Traditional IRAs, withdrawals for these purposes may be penalty-free but are still subject to income tax.

It's important to understand these rules to avoid penalties and taxes when accessing the funds in a Custodial IRA.

The Impact of Starting Early

Starting early in your child’s Custodial Self-Directed IRA can have a significant impact on the wealth they can accumulate over time. Individual retirement accounts are designed to grow through regular contributions and from the return on investments. A key factor in this growth is compounding interest, where interest, dividends, or gains are reinvested to accelerate the growth of the account. The crucial element for compounding interest is time, the longer the time horizon, the greater the exponential growth. Let’s look at some examples.

 Child #1

• Opened a Custodial Self-Directed IRA at age 10 (after earning eligible income)
• Contributed the maximum limit of $7,000 each year until age 18
• Earned a 7% return on investments annually
• Final balance at age 18: approximately $235,000

Child #2

• Opened a Custodial Self-Directed IRA at age 15
• Contributed the maximum limit of $7,000 each year until age 18
• Earned a 7% return on investments annually
• Final balance at age 18: approximately $30,500
  
  
  
  
  
  
  
  

While both children have a great start on their Self-Directed IRA accounts, Child #1 has a much larger amount simply because their account had more time to grow. Starting early can help jumpstart your child’s financial future, helping them purchase a first-time home or even pay for qualified higher education expenses.

What are the disadvantages of Custodial Self-Directed IRAs?

While Custodial Self-Directed IRAs offer significant benefits for long-term financial growth, there are a few important considerations to be aware of:

• Earned income requirement: Your child must have a source of earned income to contribute to the IRA. Allowances or gifts do not count; they must either be self-employed (e.g., dog walking, babysitting) or employed with a W-2 job.
• Impact on financial aid: The assets in a Custodial Self-Directed IRA are counted as part of the child's assets when applying for financial aid, including college financial aid. Additionally, any distributions made for qualified education expenses will be considered income, potentially impacting eligibility for need-based aid.
• Transfer of control: When your child reaches the age of majority, they gain full control of the Custodial Self-Directed IRA. It’s important to use the Custodial IRA as an educational tool, ensuring your child understands how to manage the account and avoid unnecessary penalties or taxes when they take control.
• Contribution limits: The contribution limit for a Custodial Self-Directed IRA is $7,000 (as of 2025) or the amount of the child's earned income, whichever is less. This may limit the total contributions if the child’s income is lower than the annual limit.

How do I set up a Custodial IRA account?

The first step is to choose a custodian to set up the Custodial IRA account. Traditional custodians like Charles Schwab or Fidelity offer standard Custodial IRA accounts, while self-directed custodians, such as Preferred Trust Company, allow you to set up a Custodial Self-Directed IRA, providing more control and the ability to diversify investments beyond the stock market.

Before choosing a custodian, it’s important to do your due diligence. Make sure the custodian offers Custodial IRA accounts specifically for minors, as not all custodians may provide this option. Additionally, each custodian may have different internal policies regarding account balances and annual fees. Ensure that the custodian's requirements align with your goals and that your child will be able to maintain consistent contributions to the account.

Once you’ve selected a custodian that meets these criteria, reach out to them to open the Custodial IRA account and start building your child’s financial future.

In Conclusion

Custodial IRAs can be a powerful tool for jumpstarting your child’s financial future, as long as you're aware of the underlying requirements and limits. Opting for a Custodial Self-Directed IRA gives you more control and the ability to diversify into alternative assets beyond the stock market. However, these types of investments require thorough research into the investment opportunities, providers, and associated risks. The earlier you can start, the better, but any effort to help your child save for their future will pay off in the long run. Be sure to consult a tax professional to determine if Custodial Self-Directed IRAs are a good fit for you and your child.

Preferred Trust is not affiliated with, sponsored by, or endorsed by Fidelity or Charles Schwab. The mention of these companies is for informational purposes only, and Preferred Trust does not imply any direct connection or endorsement with these organizations.