Do you understand the advantages of opening a Roth IRA rather than a regular IRA for your child? Find out how your child’s future could be financially secure by retirement age, simply by investing as little as $1,000 in a Roth IRA when they are young.
Thanks to the recent development of the Roth IRA, parents today have a golden opportunity to help their children secure their financial future. Almost any parent can guarantee their child a substantial nest egg by retirement age. Roth IRAs offer tax-free compounding earnings, and are an excellent vehicle for accumulating long-term wealth. Unlike traditional IRAs, where money grows tax-deferred, a Roth IRA allows every dollar invested to grow completely tax-free.
When you allow compounded tax-free earnings time to grow, the result is almost magical. For instance, a $1,000 original investment yielding a 10% average yearly return, will grow to over $117,000 in fifty years. If it grows at 15% (which is more typical of what the stock market averages today), your original investment will grow to over a million dollars. Clearly, if you let a Roth IRA follow its course it can produce enormous wealth, and while it’s never too late to start, what better time to begin than in childhood?
Many IRA providers will accept accounts for minors, since there’s no minimum age requirement for a Roth IRA. In fact, some providers allow you to open a Roth IRA with as little as $250. Your children can own one as long as the earned income requirements are met. Under the U.S. Tax Code, a parent or guardian of a minor child may establish a Roth IRA on their child’s behalf. However, the contribution must be from earned income the child has had for the taxable year in which the contribution was made. In other words, your child must have earned the money through some type of employment. Even if the child didn’t earn enough money to pay taxes on their wages, they could still open a Roth IRA.
For example, if you child has an after school job and earns an annual salary of $2,000 as a bus boy, babysitter, or grocery bagger, the amount earned is not enough to be taxable. Yet, he or she may still contribute towards a Roth IRA because it is considered taxable compensation income.
What happens if your child spends the money on a car or clothing? You can still open a Roth IRA on their behalf, since there’s no requirement that says that the same dollars earned must be used to fund the Roth IRA. If your child spends the money, there’s nothing prohibiting you from funding a Roth IRA for them, provided they truly earned the money.
What about parents who own a business and hire their children? Would the wages paid to their children qualify? Most likely it will, provided it’s not bogus income. For example, reasonable salaries can be paid to children as young as seven years old for clerical and cleanup tasks for the family business. Since the Roth IRA is fairly new, there haven’t been any specific instances of IRS challenges to contributions made to a Roth IRA for a child. If you’re self-employed or own a family business and wish to set up a Roth IRA for your child, you must keep accurate records demonstrating the work performed and the money paid. In other words, the child must actually do the work to earn the money. If these conditions are met, then the child is considered to be earning taxable compensation income, and may contribute up to $2,000 to a Roth IRA.
What about money earned performing household chores? It depends on if the income truly falls under the umbrella of taxable compensation income. The U.S. Internal Revenue Code establishes that all income is taxable unless an exception is made, and there hasn’t been any exception made for money paid by parents to their children for performing household chores. Possibly the only reason there’s no explicit exception to this type of income is because the IRS has never concerned itself with the situation. In the event they ever do decide to investigate it further, it might be deemed that claiming this income as taxable compensation income is utterly absurd. However, if the child is truly performing the work, and you’re keeping accurate records of the wages paid, you should be able to count it as compensation income. Ultimately, the deciding factor may depend on exactly what type of household chore is involved. For example, paying your child wages for mowing the lawn, raking the leaves, or painting the house, could be defined as services that could have otherwise been contracted out to an outside company. If you chose to have your child do the work rather than hiring an outside service, and properly document the wages paid and the work performed, this income should be allowed to qualify as taxable compensation income. However, any money paid to your child to set the table, fold socks, or clean his room, will probably fall short of satisfying the requirement. These are more commonplace household chores, and would be difficult to convince the IRS of otherwise. Trying to open a Roth IRA on these grounds would not be illegal, but risky; and you may be subjected to penalties.
Is there any drawback to opening a Roth IRA? Only one. The account will be in your child’s name; so there’s no way of preventing him or her from withdrawing it for other purposes when the child reaches adulthood. However, the benefits of owning a Roth IRA from childhood are far too great. It’s a risk most parents are willing to take.
The important message here is to keep accurate records and have the child truly earn the money. For those who can show that their children meet the earned income requirements, setting up a Roth IRA would be a wonderful step towards securing the child’s financial future. Check with your tax advisor and/or IRA provider to get started.