Tax planning and compliance for investors
Free Online Guides
By Kaye A. Thomas
Updated January 26, 2008
Can you set up a Roth IRA for a minor child? Should you?
Traditional IRAs haven't been attractive investment vehicles for minors, in part because young children seldom have enough income to benefit from the deduction. A Roth IRA for a child can be very attractive, however. There's no minimum age to set up a Roth IRA, and many IRA providers will accept accounts for minors. In most cases the only issue is whether the child has taxable compensation income.
Some IRA providers balk at the idea of IRAs for minors, but many mutual funds, brokers and banks accept them, so if you strike out the first time you ask, try again elsewhere.
Tax-free compounding of earnings inside an IRA is a beautiful idea — and a powerful one. The longer you can keep your money invested in a tax-free vehicle, the greater your wealth accumulation. What better way to accumulate a large amount of savings than to start during childhood? When tax-free compounding has more than 50 years to run its course, a relatively modest savings plan can produce substantial wealth.
There's no minimum (or maximum) age to set up a Roth IRA. And there's no requirement that the same dollars that were earned be used to fund the IRA. If your child earned money on a summer job and spent it on whatever kids spend money on these days,* there's nothing wrong with using money provided by parents to establish the IRA. The child has to have earned income, though.
* A recent report says the number one category isn't CDs or video games: it's food.
Money in your child's IRA belongs to the child. There's no way to restrict the child from withdrawing it and using it in any way he or she chooses, at least after the child reaches the age of majority. Bear this in mind before you pour many thousands of dollars into an IRA for your child.
The major impediment to IRAs for children, especially young children, is the earned income requirement. An unmarried person must have earned income of his or her own to contribute to a Roth IRA. The income has to be compensation income, not investment income. And it has to be taxable compensation income. For example, income covered by the foreign earned income exclusion doesn't qualify.
That doesn't mean your child has to actually pay tax on the income. If the total amount of income is small enough so your child doesn't have to pay tax, that's okay. But your child has to have the kind of income that would call for a tax payment if the amount were large enough.
Example: Your child earns $2,350 bagging groceries after school and during the summer. No tax is due on this amount — the only reason to file an income tax return is to get a refund of any withholding. But your child can contribute to an IRA because the earnings are taxable compensation income.
What if the parent is the employer? The fact that the income comes from a parent doesn't disqualify it, although the IRS may take a closer look in cases like this.
There have been a number of court decisions 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 allowed the deduction when it was convinced that the parents paid fair compensation for work actually performed in a real business. When the compensation wasn't a reasonable payment for work actually performed or didn't relate to a business, the deduction wasn't allowed. Bogus compensation won't support a contribution to a Roth IRA, either.
Why not use a child's earnings from household chores to meet the earned income requirement? Let's make some favorable assumptions:
Will that do the trick? Strangely enough, there's no clear guidance on this issue, but the answer seems clear enough to me. Payments to family members for household chores are not taxable income, so they can't be used to support contributions to IRAs.
It's difficult to prove this income isn't taxable. The Internal Revenue Code says all income is taxable unless an exception is made, and there's no exception for amounts paid by parents to family members for household chores. Yet this is one of those things we all know instinctively. No one ever reports this kind of income on a tax return, and no one thinks they're cheating when they fail to do so. The IRS has never suggested that this income should be reported. Just imagine the uproar if the IRS tried to collect tax on the money parents pay their children to babysit younger siblings or mow the lawn.
Here's what the late Boris Bittker, the leading authority taxation of the family, has to say on the subject:
"Intrafamily transfers of this type can be properly viewed as excludable by a higher authority than the language of [the Internal Revenue Code] — a supposition, so obvious that it does not require explicit mention in the Code, that Congress never intended to tax them."
If the income isn't taxable, it can't support an IRA contribution. You can't turn it into "good" income for this purpose by choosing to treat it as taxable income.
There's little chance the IRS will actually challenge IRS contributions based on income from household chores, at least if you keep the contributions within the limit of amounts actually paid as reasonable compensation for work actually performed. But that doesn't mean these contributions are legal and proper.
|That Thing Rich People Do||The fastest, easiest way to learn the principles of investing.|
|Our complete guide to Roth IRAs and Roth accounts in 401k and similar plans: choosing, creating, building and using these accounts.|
|Consider Your Options|
|A plain-language guide for people who receive stock options or other forms of equity compensation.|
|Equity Compensation Strategies|
|A text for financial advisors and other professionals who offer advice on how to handle equity compensation including stock options.|
|Capital Gains, Minimal Taxes|
|Tax rules and strategies for people who buy, own and sell stocks, mutual funds and stock options.|