Investment Gift Idea For Children: A Roth IRA?

A few very forward-thinking readers have asked me about ways to help their kids or other young folks by giving them a Roth IRA. This seems like an awesome idea to grab them some tax-sheltered action. I’ve thought about this in passing, but never really did the research into the technicalities of it. One good article on this subject is over at Fairmark called Roth IRAs for Minors. Combine this with official IRS publications and a few magazine articles about employing your children, and here’s what I found:

The Facts

  • There is no age requirement to open an IRA.
  • Many, but not all, IRA providers will allow you to setup an IRA account for minors.
  • The primary requirement is the child needs to have taxable earned income to make a contribution. So to make a $4,000 contribution, they would need $4,000 of income. Earned income means that dividend or interest payments don’t count.
  • An important difference between IRAs and 529s is that once the child reaches 18 or so, they get complete control over the money and can do whatever they want with it.

The Payoff
How much money are we talking about? Umm.. a lot! From the Kiplinger article:

Let’s assume you give your 15-year-old daughter $1,000 to fund a Roth IRA. If the money inside the account grows at an annual average rate of 8% — well below the long-term average return for stocks — that $1,000 will grow to about $47,000 over the 50 years it takes for today’s teen to reach retirement age. If you added another $1,000 a year until she turned 20 -? and never added another dime — that initial $5,000 investment would be worth nearly $250,000 by her 65th birthday. With a Roth IRA, the full amount will be tax-free when it’s withdrawn in retirement.

Now the question is how to obtain that taxable earned income?

Income From Non-Parental Employer
This is probably the most legitimate and straightforward way, also the hardest to get. Examples for small children might be acting or modeling from an agency not directly owned by the parents. For teens this could include money from tutoring, bagging groceries, or working at the movie theater. In addition, this income may be subject to payroll taxes like Medicare and Social Security Tax at 7.65%.

Income From Parents As Employer
Maybe you already run your own business, and could use the services of a child – web design? computer set-up or consulting? From the Fairmark article:

There have been a number of cases dealing with parents who paid children to work in the parent’s business. None of them deal with the Roth IRA, though. These cases generally deal with the parent’s deduction for the amount paid to the child. The Tax Court has recognized the deduction when it was convinced that the parents paid fair compensation for work actually performed in a real business. When the compensation was bogus or didn’t relate to a business, the deduction wasn’t allowed. Bogus compensation won’t support a contribution to a Roth IRA, either.

Also, via IRS Pub 15 it looks like there is the ability to avoid payroll taxes:

Child employed by parents. Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. If these payments are for work other than in a trade or business, such as domestic work in the parent’s private home, they are not subject to social security and Medicare taxes until the child reaches age 21. [...] Payments for the services of a child under age 21 who works for his or her parent, whether or not in a trade or business, are not subject to federal unemployment (FUTA) tax.

Income From Parents For Household Chores
This is where it gets a little dicey. According to the IRS, all income is taxable unless a specific exception is made. And there is no exception for money paid for household chores. So it would seem that counting such money as “earned income” would be fine. But when was the last time you heard of a parent giving their kid a W-2 or 1099 form for doing the dishes? It’s an unofficial, but widely understood exception.

The Fairmark article argues that because it is an unsaid exemption to treat such income as untaxable, the IRS could disallow a parent treating it as taxable later on. If so, then the Roth IRA contribution by the minor would not be legit, making it an excess contribution and subject to all kinds of penalties.

Summary
There are a variety of ways that you can give a child some earned income, and therefore a Roth IRA. If they already have income from other sources, you’re already in the clear. In the case of using “mowing the lawn” income as the basis for an Roth IRA contribution, the IRS has not issued any clear direction in this regard. You have to weigh the prospect of years of tax-free compounding with possible penalties and paperwork issues later on.

Anyways, I think if a kid has people asking these kinds of questions already for them, they are already pretty well off. :)

If you do take the plunge and open up an IRA for your child, visit Mint.com first so you can compare all of the different IRA accounts today’s online brokers have to offer.

Comments

  1. Hi – what my wife and I did to invest in our baby’s retirement was to open a RIC-E-TRUST. It’s an investment device created by Ric Edelman that requires a minimum of $5,000 to open. The trust is only accessible by the “child” when he reaches retirement age and does not require any earned income by the child.
    http://www.ricetrust.com/
    (It’s a patented method apparently and I’m not aware of any other such setups. We’re not associated with Edelman Financial other than being clients.)
    As Edelman would say, though, do not worry about your child’s retirement (or even college) until you have your own retirement situation fairly well set up. You have to come first or else your child will end up having to take care of you in your older age.

  2. I am a CPA and just heard of the chore angle recently. The thing is if you want to report that as taxable income, what does the IRS care? & I believe kids under a certain age are exempt for social security and the like. (Is it 13? Sorry, don’t know off the top of my head). You don’t need a W-2 and individuals do not issue 1099s. Since when did IRS turn down taxable income? (Though of course down the road they may think twice when they see all the ROTHs that come from this tactic. Good point).

    So this is a really simple way to pay them and also help them fund a ROTH. The IRS is happy since most people don’t report allowance income (it usually falls well under the gift limits). I think it is probably important to be consistent with your kids. If you don’t report chore income, but later do, then that’s trouble. Pick a plan and stick with it, and you are less likely to face issue. I thought this was a wonderful idea though I did want to look further into it and get more feedback from my colleagues. (Haven’t done so yet).

    Oh yes, and obviously, you have to pay a reasonable amount. Next year the IRA max is $5k. That is obviously a bit much for household chores.

    One final caveat, if you do this, keep good records of the work your child does and how they are paid, etc. The IRS doesn’t care BUT social security administration does. They WILL audit you if your child is under 12. All you need is some records, or a plan, to appease them. It’s not a biggie, but a heads up. The more documentation and proof you have, the better off you’ll be. You will most definitely get a letter from SSA if you report taxable income to your younger kids. You can send them a list of all the chores they did and that’s about it. They’ll audit you every year though. Just FYI.

    Babysitting and lawn cutting money would all be the same. If the kids are too young to pay social security; all the better.

  3. I have kids aged 1 and 3, and I was ‘this close’ to setting up Roth IRAs for them, when my financial planner asked me, “You’re paying to raise them to age 18, you’re going to fully fund their college… Why do you think it’s your responsibility to fund their retirement?”

    I think he makes an excellent point. While the compounding from such a young age is difficult to pass up, I believe that the life lesson is worth more than than the compounding. As parents, we need to remember to let our kids do some things for themselves. If your kid never has to work for anything in his life, what type of person do you think he’ll grow up to be?

    Once my kids get older, I’ll suggest that they set up a Roth and tell them why it’s such a good idea to contribute something while they’re young. At least that way, they’ll feel more ownership over the account and they’ll appreciate what they are doing with it.

    Handing an 18-year-old an account worth six figures that he never contributed a dime to is a really bad idea.

  4. I did work for my parents. At the time I worked for them they had Defined Benefits Plan and were close to retirement trying to catch up, so they were maxing their contributions. I benefited this greatly. I worked for them from the time I was 18 until I was 29. When I walked away from the business I had amassed a retirement fund worth 335k. Combined with my ROTH, rental property, and other investments, I hope to retire at 55. Got my fingers crossed.

  5. At USAA you can set up a Roth IRA for $250, I did this for my college-aged siblings Xmas gift last year to get them thinking about starting to save for retirement when they graduate (they both had summer jobs so earned income was not an issue). I projected how much the gift would be worth when they retire to show them the power of tax-exempt compunding. It got their attention.

  6. My dad showed me the power of compound interest in a nice spreadsheet when I was 18. It basically showed that I’d have a kajillion dollars by the time I was 60 if I put in x amount of money to an IRA or something else with a decent rate of return.

    I still have the spreadsheet posted up on the wall by my desk, as a reminder, but I could’ve gotten a four-year head start had he actually started one for me, instead of leaving it to me to figure out how!!

  7. ParatrooperJJ says:

    Teri- Why don’t you have to issue a 1099 or a W-2? Is it not the same as hiring household help such as a nanny or maid?

  8. Or you can just help support your kid’s education and give them the tools to save for their own retirement. My grandparents gave each of the kids Canada Savings Bonds for x-mas every year (low-interest, government bonds cashable at any time).

    As I understand it, pretty much every grandchild to date has used the money for education, and it’s given everyone a small taste of investing.

  9. Obviously, the whole “earned income” thing makes this difficult. How about just sticking money into a regular IRA for them? Does that have to be earned income? Then, once they start working (even at a part time job during high school), maybe they could convert $10K out of it every year into a Roth.

    A question though — does having money in a Roth effect your chances at getting financial aid/scholarship from a college?

  10. Jonathan, 529 accounts seem superior to Roth IRAs. Both are grow tax-free, but the advantages of a 529 include:
    + Access to cash at college age rather than retirement age.
    + Ability to contribute up to $120K per year (from a married couple) without having to worry about “earned income”.
    + Flexibility to switch beneficiary from child to child, even to your sibling, or your sibling’s children, or even to yourself.
    + Complete control of account no matter who is the named beneficiary.
    - Money must be used for educational expenses. But the definition is broadly worded and includes tuition, books, room and board. Basically don’t put in too much (akin to a medical savings account).
    The details vary by state, but here is California’s which is managed by Fidelity.
    http://personal.fidelity.com/planning/college/content/fidelity_529_facts.shtml.cvsr?banner=scholar

  11. I had a once-a-week paper route as a teenager, and my dad opened a Roth for me and he contributed to it. It was a nice head start for me as I became an adult and I didn’t feel like I was starting from scratch in terms of retirement savings.

    Having a Roth already set up when I graduated from college made it easier to start my own contributions for retirement because I didin’t have to go though the process of setting up a new account, which can be pretty daunting when you’re a young twenty-something and don’t know much about personal finance.

  12. I’ll stick with the 529. My niece will go to college and I know I would have loved having thousands for college when I was 18.

    If per chance my niece doesn’t go to college and if I have kids they’ll get her 529. The money will be used. At the worst, my wife can use it for law school. ;)

  13. I have been touting this for years; indeed, I think an intersting idea would be to start a local “chores co-op” where parents employ OTHER ppls children to do chores (and theirs do the same) for legitimate wages (have to figure out how to avoid the SS/Medicare crap) and then all earned income goes directly to a Roth IRA…

  14. Thanks for this website, it has helped me a lot with understanding some of my finances. I am an ignorant in this field so this site with very usefull for me.

    My question is How many IRAs account can you open?

  15. Thanks! I believe you can open as many IRAs as you want with different brokers, you just have to remain within the contribution limits.

  16. i’d be very careful about chore income as means to fund RIRA for a child.

    Second, the kid has to have earned income up to the contributed amount. the kid RIRA is not like a spouse.

    third, the kid has full control over a RIRA regardless of age, since the RIRA is in the kid’s name. There is absolutely nothing you can do if the kid cashes the RIRA out.

    Jansy: you can open up as many as you want, from as many places as you want, in either a mix of TIRA and/or RIRA so long as what Johnathan stated, the total contribution remains within the contribution limits per person per year.

    Neonate: minor edit is that RIRA contributions can be withdrawn before retirement without penalty, only earnings will be subject to penalty.

    Mimi: you still need earned income for a TIRA. IRA affecting financial aid, depends on the school, but most do not include it in the equation. The only time would be if you were to withdraw earnings in order to fund school, in which case it is considered income.

    I think Fairmark does a good job and laying out RIRA for minors: http://www.fairmark.com/rothira/minors.htm

    i’m on the fence about a RIRA for a minor versus a 529 or EDU Bond, but it comes down to what goals you are trying to instill in your child. When we have kids, I will probably do both. However, I would not help fund a RIRA for the purpose of using it to fund education expenses, which is allowable. It just defeats the purpose of the RIRA.

  17. other options with some flexibility UGMA/UTMA’s or ESA’s.

  18. I have $5,000 for my 1 year old child, and I would like to put this away for her retirement. Where is the best place to put this money so they can not get to this money, until they are in their mid 30′s. hopefully they will be wise enough at this point to leave it alone and let it grow.

  19. Can you transfer a Roth IRA from you to your child? I was thinking, why couldn’t I open another Roth in my name, then, sort of roll it over (even gradually) into my child’s account when they are old enough to start earning income? Would this be a problem? Or would it be considered a gift? Or, if I just left it in my name with the child as the beneficiary, would they have a problem paying too much in estate taxes?

  20. Some of you people are missing the boat.

    The Roth IRA for a minor does not necessarily have to be for their “retirement”. Yes you need to fund your own retirement first! The main reason most would use this is that they can take it out for a COLLEGE EDUCATION, or buying a home without penalty. Therefore you can basically using this vehicle as an educational IRA if they have qualified earned income.

Trackbacks

  1. [...] Investment Gift Idea For Children Pending interim grades that are conveniently mailed home 6 days before Christmas (lol), BabyGirl may get one or two things at the top of her Christmas list. However, my primary focus is preparing her for a financially fabulous future. She may not care about these things now, but she’ll love me for it later. [...]

  2. [...] blog has a pretty good write up of the ins and out of this options, it’s worth have a look at for more information. Note that you can also get custodial accounts for all sorts of bank products, not just ROTH [...]

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