My 3-year-old daughter Arabella might have a bigger Roth IRA than you. And if she doesn’t, she probably will one day — without ever adding another penny.
Let me explain. When Arabella was 2 months old, my wife and I opened a custodial Roth IRA for her. Arabella started earning income that we could put in a Roth IRA and invest for her. Her Roth IRA now stands at $17,700 and will grow to over $2.4 million by the time she is 60 (assuming a 9% annualized return), without ever adding to it.
The best part? That $2.4 million will be completely tax-free when she’s able to pull it out due to the tax benefits of the Roth IRA. And if we decide to contribute more by making modest contributions of $1,000 a year, less than $90 a month, it will grow to over $4 million by the time she is 60.
How? Well, I’ll explain.
How It All Started
When my daughter Arabella was about 2 months old, her mother Samantha started a boutique called Shop Bella Bae, a child hair bow company founded with the mission of inspiring and empowering moms and their daughters.
Shop Bella Bae got its namesake from Arabella, and since its launch, the business has grown quickly from an online-only boutique to being featured in multiple local shops in Phoenix, AZ where we live.
Samantha began using Arabella as a brand ambassador and model for her products on Instagram and the shop website when she was a newborn. Arabella was the inspiration for the business, and Samantha wanted to bond with her to create positive memories while overcoming postpartum anxiety and depression.
As an award-winning wealth manager and certified financial planner myself, I realized this presented an amazing once-in-a-lifetime opportunity for Arabella — where she could build wealth by taking full advantage of compound interest and tax-free growth with a Roth IRA. I was over the moon with excitement for our baby girl.
I believe parents should empower their children to participate in their own financial wellness (in an age-appropriate way) to promote financial literacy. This not only benefits children, but it benefits the entire family, as it will increase critical financial dialogue and financial awareness. That’s especially important in minority and disadvantaged communities.
So I suggested Samantha pay Arabella through the business to compensate her for the modeling services she provided for the brand. By doing so, it ensured that we could start a custodial Roth IRA in Arabella’s name — at just 2 months old.
Arabella’s Investment Portfolio
In my professional career, parents often ask me, “How do I set my child up for financial success? What is the best type of investment account for my child?” I often remind parents that it is indeed very doable to build wealth for their child and instill financial literacy from a young age.
I most often speak about the benefits of setting up a Roth IRA for their minor child, also known as a custodial Roth IRA. A Roth IRA is a powerful wealth building tool that allows investors to invest their money in the stock market and grow their wealth exponentially over time. The money is able to be taken out tax-free when the investor is 59 ½ years old. It works the same way for a custodial Roth IRA, except my wife and I invest the funds on our daughter’s behalf.
To reap the maximum benefits from a Roth IRA, you want to allow the account to grow for as long as possible, and you want to make contributions while you are in low income tax brackets. Roth IRAs typically allow you to deposit $6,000 a year in 2022 (or your taxable income for the year, if it’s less than $6,000) while you’re making earned income, and $6,500 in 2023 if you’re under 50, and $7,500 if you’re 50 and older. A minor typically benefits from the length of time in the stock market, and the lower tax rates.
The essential requirement for making a contribution to a Roth IRA for your child is that they must have earned income. The IRS defines earned income as “all the taxable income and wages you get from working for someone else, yourself or from a business or farm.”
For your child, earned income might include working a common job like a grocery store worker or fast food worker, or a nontraditional job like running errands, cutting grass, babysitting, pet sitting for a neighbor, etc.
Arabella received earned income for modeling and being the brand ambassador for Shop Bella Bae so she qualified for a custodial Roth IRA.
Step-by-Step Guide on How We Did It
Here’s how we were able to pay Arabella when she was 2 months old.
Shop Bella Bae is a sole proprietorship, reported under schedule C of the 1040. Because Arabella was only 2 months old when she started, and due to the nature of modeling and being a brand ambassador, Arabella was paid as a contractor, so she received a 1099 from the business.
Each year, Shop Bella Bae’s accountant produces a 1099-NEC for Arabella to report the amount she was paid. The amount that Arabella gets paid also works as a deduction for the company, reducing its annual taxable income. Shop Bella Bae also files a 1096 form which summarizes the total contractor payments for Shop Bella Bae.
Arabella has owed some income taxes to the IRS and the Arizona Department of Revenue each year, although minimal when you take into account the benefits of her Roth IRA.
Before setting up a custodial Roth IRA for your child, I highly recommend consulting an experienced tax professional who is either a certified public accountant or enrolled agent of the IRS. Each family’s particular situation will differ.
For those looking to open a custodial Roth IRA for their child, be sure follow these steps:
- Ensure your child has earned income
- Consult with an experienced tax professional for proper tax reporting
- Determine your child’s contribution amount
- Open and fund the custodial Roth IRA for your child
- Invest the money in investments that are appropriate for your goals and risk tolerance
Invest for your children as early as possible to take full advantage of compound interest, even if you start with just $10 a month.
Arabella’s Financial Portfolio and Contribution History
Since Shop Bella Bae opened in January 2020, we have made the following contributions:
In 2020, we contributed $3,900 to her Roth IRA account.
In 2021, we contributed $4,200.
And in 2022, we contributed the maximum amount of $6,000.
Arabella’s Roth IRA has grown nicely since 2020, up 26% since we opened the account for her. The account benefited from increased contributions when the stock market was down, like it was in the first half of 2022.
Because she is only 3 and has over 55 years until she will need her Roth IRA, being aggressive and taking on risk will benefit Arabella in the long run.
I’ve invested in her Roth IRA quite aggressively, while also diversifying, to maximize long-term growth. The high reward, high risk approach includes a mix of low-cost stock ETFs that track most areas of the stock market, including U.S. stocks and foreign stocks.
The breakdown of her investment allocation is as follows:
35% U.S. small-cap value stocks
15% U.S. large-cap value stocks
10% S&P 500 Index
10% U.S. real estate (public REITs)
10% Emerging markets stocks
10% International large-cap value stocks
5% International small-cap value stocks
5% International large-cap core stocks
Most brokerages, or places to open an investment account, that offer a custodial Roth IRA have a full range of investment options from ETFs to mutual funds to individual stocks. I generally recommend low cost, diversified ETFs that are appropriate for you and your child’s goals and risk tolerance. The longer the investment horizon, the more aggressive you can be with your investments. But remember to consult a professional in your area if you’re unsure where to start.
How You Can Do the Same for Your Kids
Not every parent will start a Roth IRA for their child at 2 months, and that is OK.
If you start investing for your child today, no matter their age, you can still give them a phenomenal head start. You will enable your hard-earned dollars to take full advantage of compound interest.
Like the saying goes, “the best day to invest was yesterday, but the second-best day is today.”
So the earlier you begin investing for your child, the better.