The Toddler IRA: Should My 3-Year-Old Have a Tax Shelter?

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I love my Roth IRAs. They just keep on growing tax-free and never send me any annoying tax documents. Vanguard has a post about Working teens and Roth IRAs. I like the idea of a teenager putting some hours in at Jamba Juice and having the discipline to tuck some away for the future. However, the article suggests that you gift your teenager money in order to fund the Roth IRA (with the teen keeping their earnings).

Why wait until they are teenagers? You could take this further into what I call the Toddler IRA. Basically, you find a way to have your 3-year-old (or 6-year-old, etc.) have some earned income, usually via your small business. Maybe they “model” in an advertising spot. Maybe they did “administrative work” and helped organize some business papers for you. Can they weed or dig? Time to pay them for their lawn maintenance skills. Now that your kid has earned income, they (you) can contribute the same amount into a Roth IRA.

At first glance, it’s a little weird. Can I really justify these payments? I’m inclined to pay them more (so I can stuff more contributions into the Roth IRA), but would I really pay that much money if they weren’t my kid? Some parents go as far as making arrangements with other parents where they pay each other’s kids. In fact, there used to be a website (I forget the name) where your kid did some sort of simple online “work” and they would send your kid a check. (The parents would pay for this passthrough employment service.) Yet another example of government incentives working in unexpected ways.

The math sounds pretty impressive when you compound returns tax-free for 60+ years. $1,000 at 6% annual return times 60 years = $33,000. $1,000 at 8% annual return times 60 years = $100,000! Here’s a simple chart from Vanguard that shows the possibility of your kid getting a $100,000 head start on retirement:

I would add that the effect is exaggerated because doesn’t take inflation into account, but even a 4% real return will make $1,000 into $10,000 after 60 years. You put in $1,000 times 12 years, they end up with close to $100,000 inflation-adjusted after 60 years.

Why my kids don’t have a Toddler IRA. I have a small business. See that cute picture on the top right? I could easily pay them to model for a new photo shoot every month. (Trust me, it’s hard work to get them to all smile at the same time… for me.) I’ve thought about it. In the end, it doesn’t fit in with my personal philosophy about teaching them to fish:

Give a man a fish, and you feed him for a day. Teach a man to fish, and you feed him for a lifetime.

This act is giving them a big pile of fish. It’s a tax-advantaged gift, but still a gift that they’ll know about at a young age. I don’t like the idea of them turning 18 and finding out they have $XX,000 waiting for them without doing any work.

What about “teaching” them to save? If they don’t feel the pain of earning the money and the separate pain of not spending it either, then I don’t really see the educational benefit. When they start to really earn money as teenagers by waiting tables or bagging groceries, then I will consider doing some sort of 401k-like matching program as a “carrot” to letting me teach them about investing and IRAs.

When they are kids, I will instead contribute any money towards college tuition via a 529 plan. I doubt that I’ll be able to cover full tuition and housing for three kids anyhow. Most parents can’t. Above that, I’d still rather give them $500 to start a food stand at the local farmer’s market than stick it into their IRA.

I feel this is a topic where opinions will vary widely. What do you think?

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  1. Francis Schommer says

    I wouldn’t save money in a 529 because when your kid fills out the fafsa (federal financial aid for students) then the government will subtract whatever is in the 529 from what aid they could get. So if you save $100k in a 529, the government will give 100k less in aid.

    I could be wrong though.

    • My understanding is that 529 assets where the parent is the owner and the child is the beneficiary are considered parental assets when it comes to FAFSA. So it wouldn’t really affect your aid. IRAs are not counted at all in the FAFSA, whether owned by the parent or child.

      • Francis Schommer says

        So it’s just if the child is the owner?

        That does make sense. Thanks for clearing up my misconception!

        What benefits for the 529 do you want to use it for?

        • This advice is dead wrong. Any 529 assets held by the parents will be considered financial resources to be applied to the cost of college (although it’s not a 1-1 deduction in financial aid, as Francis suggests). Generally speaking though, 529 assets will most definitely reduce the financial aid your child receives. This is why you should be maxing out every conceivable retirement account before putting a dime into a 529 account. Retirement accounts are not included in the calculations of what a parent can/should contribute to their child’s education. More information can be found here:

          The best recommendation is to have grandparents fund a 529 account and then only use it to pay for college expenses in the child’s last (presumably 4th) year of college.

  2. I agree Jonathan. Putting money into a youth’s IRA seems like lawnmower parenting to me.

  3. I recognize that some commonly used legal avenues for avoiding taxes or taking advantage of tax advantaged strategies feel like they are not in the spirit of the intention of providing the benefits – in such cases, I am all in favor of taking advantage to the fullest extent within the law.

    However, I feel what you are describing is illegal. I have seen the topic debated in various forms and I believe a legal opinion would be that the arrangements that you describe for a very young child would not reflect actual earnings but rather a scheme to funnel money to family/friends for tax purposes (not sure the appropriate legal term). I would caution readers to stay away from this sort of behavior as I believe it is less of a grey area than some people think and I believe there could be legal consequences.

  4. This is interesting, I actually like this more than a 529 plan, how is that not also giving them a pile of fish, but fish you can only exchange for “education”.

    My bigger objection is that your cheating the system, 3yo don’t earn money, and to claim they do is lying. I have a 6yo and I pay him quarters to help with groceries shopping, at that age I can see them doing work but are there child labor laws we need to worry about? How do you properly report this work to the Irs?

    Is it possible to somehow put the money in your own Roth and then somehow later via death or gift to transfer it to theirs?

    I totally understand teaching them how to fish, but it’s also a lot easier to fish when you start out with a fishing boat rather than a fishing rod 🙂

    I also have added my child to my credit card as s authorized user, and hope to build their credit giving them what I hope is yet another advantage.

    • I agree that 529 is also like a pile of fish, but the difference is exactly that it is forced to be exchanged for education at an young age, not squirreled away as cash to pop up at age 60. It is not that you shouldn’t spend resources on a child, I totally plan to expend tons of resources, but that perhaps it is better that the resources are the in the form of education instead of assets.

      With education, the child is an active participant and changed in the process. If I pay for music lessons, the kid has to go and put in their own time and effort, and are forever altered in ways that I can’t predict. If I just hand them $100 bills as an adult and no music lessons, that’s different.

    • Child labor laws only apply to children that are not your own. You can work your own kids to the bone and pay them nothing. That’s one reason why farmers historically had a lot of children.

  5. boomalog says

    I worked starting at 16 and my parents didn’t make me pay any gas, insurance or anything. They let me keep all my earnings. Even at that age I saved it all. It would have been nice to know that i could have put the money into a Roth at that age, but my parents didn’t know about that stuff. I like your idea of the matching program, that’s even more of an incentive. I’ll probably do that for my kids. On another note, I was looking for college costs for my now 6 year old and it’s projected with room and board it will be @175k by the time she’s 18. For you, how much money are you putting into the 529? Are you assuming all 3 will go to college? Do you have 3 529’s, one for each kid?

    • I do have three 529s, one for each kid, but the odds are that it won’t grow enough to cover 4 full years of college for each kid. If one does not use the money, I can easily change beneficiaries and help the other ones. Or it could be used for graduate studies. Or it could be used for adult education. Or kept for grandchildren education. I don’t really worry too much about that. The odds are much higher that I will run short of money, rather than have too much.

  6. I think the concept, in theory, is appealing, but some of the methods to generate the toddler income may be problematic.

    The underlying issue is the question of the fair market value (FMV) of the toddler’s services. If not FMV, the IRS may say the service payments are not all income. If the FMV of the services were to be readjusted downwards, you’d have:

    1) A smaller deduction for your business.
    2) An IRA contribution greater than income for the toddler.

    Agreeing with another parent to pay each other’s child was likely an attempt to make it appear FMV. But, absent the reciprocal payment, would either party pay the other’s child that amount?

    The website that no longer exists likely got into trouble for helping manufacture income for this purpose.

    Again, I think it’s a great idea in theory, but not sure how much most could pay their kids and not run into issues if it were scrutinized. Although it may still be worthwhile to some on a smaller scale.

    • I agree, there are many potential issues, I’m just treating things on a high level here. The additional documentation and tax paperwork plus IRS concerns are definitely another reason why I’m not going down this route.

  7. The Frugal Millionaire says

    I am not a parent so I might be off base here, but wouldn’t you have to withold and pay federal and state taxes, as well as pay into Social Security and unemployment insurance on your children’s behalf? We once hired a home aide for my mother-in-law, and the tax paperwork was brutal.

    • I’m pretty sure you’d just treat them as an independent contractor, not an employee. But yes, there would be extra paperwork and your child will have to file a tax return and pay any applicable taxes first as with any Roth IRA.

  8. Why not give them a pile of fish but also teach them how to fish?

    • The short version is that I don’t have unlimited fish (past paying for college tuition and other educational opportunities) and there may be negative effects of a young adult being handed significant amounts of cash without doing anything to earn it.

      • Are any of these negative effects you mention documented in studies, or is it just a feeling you have or is it simply wisdom passed down to you from others? I know of some notable examples of people who were born wealthy and were successful. Two that come to mind are Mr. Fred Rogers, and Paul Getty (who was once the richest person in the world).

        I think people confuse or assume that if you give money to your child, you are removing obstacles in their life, or spoiling them, when this is not necessarily the case.

        • There is no right or wrong answer, just my opinion. I don’t think that a big inheritance is guaranteed bad or good. You can certainly find examples of both. (I also don’t know if the Getty family is the best example of a family who handled intergenerational wealth wisely.)

          It’s like many other financial things, value is getting the most bang for your buck. If you don’t have infinite resources, how do you deploy them most efficiently? I think spending them the way I outline in my past post is the best bet. Teaching them to fish. Giving them money – could be good, could be nothing, could be bad. Therefore, funding an inheritance now via kiddie IRA is not the highest value in my opinion, and thus low on my priority list.

  9. I can’t speak to the idea of a 3 year old with an IRA but I did put $5,000 into a Roth for my daughter when she was sixteen and had her first summer job. She is now 37 and still has the Roth and never touched it. The S&P was about 1200 then. Thanks Dad…

    • Nice! Out of curiosity, how did she earn $5,000 when she was 16? That would be 500 hours of work at $10 an hour.

      • Better yet. 37 years old minus 16 years= 21 years ago, which was 1998, first year of Roth. Max contribution was $2000.

        • to Jonathan: She worked at the Mountain View Movie theaters. (she also had a job during school)

          To Pete: I have no idea what the limit was but I put $5k in her Roth and never had an issue.

  10. Pay 1/3 of expected in-state public university costs, get aid for 1/3, and then pay off the remainder 1/3 using Roth IRA
    – Do not use Roth IRA to fund college as it will be income counted against you. Instead, just use it to pay the student loans after child graduates (or on 2nd year if it looks like he is going to graduate in 4)
    – Contribute about 200/mo (don’t over fund)

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