I grew excited: The prospect of a Roth IRA compounding over decades, tax-free, beginning when the beneficiary is in the single digit age range was too tempting not to explore. I’ve been encouraging my kids to save and invest in the Bank of Mom and Dad. Perhaps those savings could be channeled into a child Roth IRA?
I reached out to a select few blogger heroes, garnering occasional generous responses (are your ears burning, Physician on Fire?) that pointed me in the right direction. Where does one go to learn how to comply with federal law for kids too young to earn income by mowing lawns or flipping burgers? Naturally one seeks counsel from the oracles atop the mountain: the collective wisdom (both moral and financial) manifest as the Bogleheads Forum.
I reviewed twenty-odd relevant threads on the forum from the past decade, which I’ve condensed for your convenience. Without further ado, following is what the Bogleheads taught me about a child Roth IRA.
What are the requirements to open a child Roth IRA?
While there is no age minimum for establishing a Roth IRA, the child must have earned income.
Money that qualifies as earned income can include W-2 income (for employees) or self-employed income. Examples might include babysitting, mowing lawns, shoveling snow from driveways, modeling, flipping burgers, tips from waitressing, stuffing envelopes at mom’s office, or sweeping floors and setting tables at the family restaurant.
Money that does not qualify as earned income includes being paid for routine chores at home (cleaning room), allowance, grandparent gifts, winnings from chess tournaments (interestingly, these are taxable, but not considered earned), and finally interest and dividends on investments.
Note that there is some ambiguity here. Income earned from third parties (neighbor paying your kid to babysit, mow their lawn or shovel snow from their driveway) clearly qualifies as earned income, with the admonition that the child should keep records of amounts earned and date/hours worked in case the IRS ever comes knocking.
What about if you pay your child for similar work? If you pay your child a reasonable amount to mow the lawn weekly, keeping meticulous records of payments and jobs, this could pass muster as earned income. The key is that it must be reasonable remuneration (not mowing lawns at a hundred bucks an hour) for actual work done, and your kid must keep records of their real lawn-mowing business. If unrelated kids could earn a similar income for this type of work, it’s valid.
And yes, crotchety old grump, it goes without saying that your dad and mine would never have paid us for this stuff. What’s the matter with kids today?!
Nope! You can provide a “parent match” where the kid keeps his earnings and you match the amount up to the limit and contribute your own money. Since at writing individual gift limits are $14,000, and Roth IRA limits are $5500, you need not fear that your parent match will exceed legal gift limits.
A few Bogleheads suggested your kid funds half (to train those saving muscles early), you match half, and your kid gets to spend the remainder as a reward for hard work.
What’s the most tax-favorable entity for paying your kid earned income?
In a parent-owned corporation where the kid is an employee, you are responsible for withholding federal income tax as well as paying social security, medicare, and unemployment tax. It gets expensive, and the added costs may not justify the hassle.
You get far more favorable tax treatment if you are running a family business that is either a sole proprietorship or a partnership where the parents are the partners. In this case, you can hire a child to work for a family business without paying 1) social security, 2) medicare, and 3) unemployment tax. This legacy (from the days when large families were necessary to run the family farm) puts you at a unique advantage in hiring your child through the family business. Note that the child would still pay federal income tax on any income over $400.
Will it pass the IRS’ sniff test?
The courts have not looked at child Roths specifically, but for family businesses the criteria are: fair wages for work actually done in a real business. This has several implications.
First, it would behoove the family business (and the child) to maintain precise records of what work was done, when, and what junior was paid for that work.
Second, be familiar with fair market rates for the service in question. Paying excessively, whether for mowing lawns or child modeling, could be a red flag for the IRS. Another red flag may be earned income that serendipitously sums to $5500, which is the annual contribution limit at the time of writing.
Finally, ensure your business is a legitimate business – occasional unscrupulous voices tout how easy it would be to post photos of your kids on an unprofitable website and pay them to model – if it’s not for a real business, or if your business makes no profit, the IRS may regard it as a ruse for illegal wealth transfer.
Use the ambiguity here to your advantage – a medical or dental office that uses photos of smiling kids as part of their advertising brochures or website can be considered a valid business expense.
Will it pass the Bogleheads’ sniff test?
The forum brought up a number of probing questions that would not necessarily dissuade me from starting a child Roth IRA but are valid food for thought. A few of the most provocative:
-Has anyone else hired your kids to model for similar rates?
-Would you pay unrelated children similar rates?
-Why pay your own kids when you could get stock online photos of other kids for far less?
-If you don’t use a professional photographer and professional equipment, how can you justify paying your kids rates commensurate with professional child models? (Put another way, can photos taken on your cellular phone truly equate with professional modeling photos?)
-Does your website have anything to do with kids such that it makes sense for them to appear on the site?
Will it pass your moral sniff test?
Doing something technically acceptable but morally dubious might slide past the IRS, but may not be an example you’d want to set for your child. Be certain you feel morally comfortable with opening a child Roth IRA.
When can your child access the money in the Roth IRA?
At the age of majority, 18 or 21 depending on the state you live in, the child assumes total control of the account. This means junior can withdraw the full amount and spend the money on hookers and blow. Teach your children well…
If you are looking to gift a kid some money to invest and compound over time, consider an UTMA, a custodial account in their name that they assume control over on reaching the age of majority. Pros: Far less hassle. Cons: taxable, and they can still spend it all on hookers and blow once they’re 18.If you are worried junior may spend her UTMA, consider opening a 529 account to fund her education. You retain control over the funds, and can change the account beneficiary at any time.
What type of record keeping is needed if I fund a Roth IRA for my child?
If your child is self-employed and was paid solely in cash (i.e., babysitting/mowing lawns), the child needs to file a federal tax return (form 1040) documenting earned income. This way the Roth IRA is justifiable should the IRS ever question it. If you paid your child, keep a ledger where you track date of services, amount paid, and hours worked. If your child was paid at least $600 from a single person or company for services provided, they should receive a 1099-MISC form from the employer reflecting that income. If your child worked as an employee, hang onto any W-2 forms.
Is the tax tail wagging the dog?
In my zeal to minimize taxes (distinct from tax evasion, which is illegal) I was going a bit overboard. At present, if my unprofitable blog business spent a large amount on advertising to pay related child models who then opened child Roth IRAs, it might be interpreted as illegal wealth transfer.
As we already fund 529 accounts, I’ve decided to create separate taxable accounts for each kid and invest them in a total stock market fund for now. Each kid will have monthly sit downs to follow the market and witness both short-term volatility and long-term compounding effects, for a firsthand experience in learning their risk tolerance. Hopefully this early exposure will create responsible savers and investors in the long haul.