In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses how you can start a Roth IRA for your minor child and the rules surrounding funding of the plan.
Opening a Roth IRA for Your Child
Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s Adam Talks, going to be chatting about what you need to consider if you want to open a Roth IRA for your child. This is a fun topic; done this probably every year for the last several years either via podcast, video, blog, because I get this question a lot, right, from friends, family, and clients saying, hey, I have a child. This is the situation. What do you think, Adam? Should I open a Roth IRA? So, what I want to do on today’s Adam Talks podcast is kind of go through some case law, go through some of the rules, talk about some of the tax filing requirements, and then kind of put it all together.
So, let me just set the agenda. The first thing we’re going to talk about is why? Why would you want to open a Roth IRA if you’re a kid? Pretty simple, self explanatory. And then second, we’re going to talk about some of the case law, age, bona fide service, the reasonableness of the compensation, talk about potentially who should be paying that child, and then ultimately, should you do it, level risk. And then what are some of the filing requirements for you and your child if your child earns some compensation.
So, number one, why do you want to do a Roth? Why is it super important to try to get a child into a Roth IRA? Well, pretty simple, right? Roth IRA is an after-tax account. So, that means that if, you don’t get a tax deduction for making a contribution to a Roth IRA, but, so long as you’re over 59 and a half and the Roth’s been open at least five years, everything is tax free. So, everything you pull out of the Roth IRA is tax free; 59 and a half, five years. Pretax IRA, you do get a tax deduction for making that contribution. The most you can put into an IRA (traditional, Roth) in 2023, $6,500 or $7,500 if you’re over 50. Yes, you need to have compensation for services to make a contribution. Spouses can piggyback off each other, kids cannot. So, the kid actually needs compensation. What’s compensation for services? It’s 1099. W-2, business income; it’s not interest, dividends, royalties, rental income, capital gains, Social Security, disability, gifts. It’s not something that’s not compensation, okay? A hobby, for example.
So, now we understand the Roth, talked about what are some of the requirements, compensation. Let’s now play around with some examples. So, why is it so important to start early? So let’s say someone starts at 14 and they just put in $1,500 a year from 14 to 72. So, even though they’re going to make more money when they’re 25, 45, 65, let’s just assume they just go $1,500 all the way from 14 years old to 72, assuming an 8% rate of return, which is below historically, what the S&P 500 has returned over the last 100+ years. $87,000 of contribution will turn it to $1.7 million when they reach 72. Now obviously, inflation, time, value, and money, $1.7 million will not be worth $1.7 million today, but it’s still going to be a lot of money.
Let’s say instead of 14, they started at twelve. Same numbers. Just to show you what’s going to happen, $2.03 million, right? So, they only made another $3,000 in contributions, but they have an extra $300,00 or $400,000 in value because of the time, value, and money.
Let’s say instead of twelve, they started at eleven, same 8%, $2.194 million. So, it was another $200,000 by making a $1,500 contribution. See? The idea is, the earlier you start, the more wealth you’re going to have. Instead of an 8%, let’s say you were able to get a 9% rate of return, right? $3.467 million, right? So, contributions matter, but also your rate of return matters as well. Instead of 9%, let’s say you only get a 7%. You’re still talking $1.4 million. So, it’s still real money. So, you can see why people are clamoring to do Roth IRAs for their kid.
Now let’s talk about the rules. I’m going to start with some parameters and then we’re going to go into case law and explain what they are. Here are the parameters to consider. Number one, there needs to be a bona fide service; paying your kid to wake up every morning, go to school, is not a bona fide service. Paying your kids to do their homework is not a bona fide service. But, if you have a business and your business is paying your kid to do inventory checks or build a website, or to do some t-shirt modeling, or to do sweeping up the factory floor, or to serve people at the restaurant, that is bona fide. If your neighbor or your friend or your cousin or your aunt or uncle pays your child to do tutoring or basketball coach or swim coach or whatever the case may be, that is more bona fide.
The issue is you want to have some type of employer-employee relationship, and having yourself directly paying a child without a business-employee relationship is problematic. So, your business can pay your child for a bona fide service, assuming it’s a reasonable amount of compensation, but you personally cannot pay your kid because it’s not in the business context. But a non-parent could pay a child for a service without a business, i.e. math tutoring, that is okay. So, the issue is when the parent pays the child without any employer-employee relationship, when there’s no business. If you don’t have a parent-child payment environment, then you have more flexibility because a neighbor, for example, does not need to have a business, a restaurant to pay the child. The neighbor can pay the child for babysitting or basketball coaching, okay?
So, that’s the thing to keep in mind. When it’s a parent-child, you want to have a business paying the child. Obviously, it needs to be bona fide service, reasonable compensation. If it’s a non-parent, more flexibility; you can pay for non-business-type services, but still needs to be bona fide employment, i.e. babysitting or basketball coach.
So, let’s go through some case law, some revenue ruling. Some of these are rules because people have been trying to do this for a long time. In some of these cases, they’re actually trying to do this to get a deduction. It’s really not about the Roth IRA because some of these cases are before the Roth. For example, this revenue ruling’s from 1972, and the question was whether wages paid by father to a child for personal services rendered as a bona fide employee was deductible? And the IRA said, “where the facts show that the actual services are rendered by a taxpayer’s child as a bona fide employee in the operation of the taxpayer’s business, that the compensation paid for such services is reasonable and constitute an ordinary and necessary expense of carrying on such business, such wage payments are deductible as a business expense,” and they’re deductible, that means they’re bona fide and the child could take it in to income. So in this ruling, the idea is the wages need to be reasonable and there needs to be a bona fide employer-employee relationship.
This next case is Lorraine Tucker. It’s a Tax Court memo case from 1979. In this Tax Court, there is a fact pattern where Lorraine Tucker, in 1972, she operated a grocery store and she slept in the building, in the back of it, and she had her son assist in the business, okay? And the son worked before at 7-11, so it had some experience. And the issue is whether the son was able to work and whether the compensation paid was deductible. So the son did like, clerk stuff, ordering, groceries, things like that. And the Tax Court held that it was real ordinary services and thus the compensation was deductible.
This next case, Anthony Formlansky was a Tax Court case from 1974. This guy was a doctor of medicine specializing in neurology; he had an office in California, and he basically paid his kid to do certain types of research, repairing equipment, secretarial work, not, obviously being a doctor. And the doctor claimed a deduction for the kid. The IRS disagreed, and basically what the Court said is this – the doctor admits that his child were not qualified to practice medicine (no kidding), and that they performed services in connection with answering phones that could not ordinarily be performed by high school or college-aged children of similar intelligence, similar instruction by their father, oh sorry, that could be performed by a similar-aged child. The doctor failed to prove what hours and what days they worked, and if they actually performed work. There’s no indication in such record of services were required, specific time or that they were limited by their hours. So the issue is, did they actually do this work? And they were given no information on any proof that there was any of the expenses occurred. But the Court did allow for the deduction for secretarial services performed by the spouse, but not the child. Why? In this case, even though the services were services that could be performed by child, there wasn’t proof. There was like, no email address, clearly; no clock in, clock out. They couldn’t prove that the kids were actually in the office answering the phone. So, good example, good tip. If you are going to hire a child in a business, get him an email or get her an email, right? Proof; have them clock in and clock out; have a computer so they can show whether they’re logging in or logging out; have proof that they’re actually doing the work. That’s going to help.
Another revenue ruling: 73-393. This ruling, reasonable wages paid by father to his child for services rendered in an employee’s trade or business are deductible, even though the child used the wages for part of his own support. They said the meals weren’t deductible.
This next case, Tax Court case, Nathaniel Denman. The Court held that expenses for reasonable amounts paid to the minor children performing light duties relating to the engineer’s individual businesses are deductible. Okay, so during 1957 and 1960, the sons, either individually or collectively performed various tasks, ran errands, provided various services, washing windows, screen, shoveling snow, moving grass, things like that. The business which the sons alleged performed these services was a basic and experimental physics. So, there was some hard labor there. And the plaintiff contend that amounts paid by the company for the minor children were services rendered as part-time office boys, and they were ordinary and necessary for the business, and they were reasonable. And the Court agreed, okay?
So, the key is you got to actually perform the service. They need to be services that a child at that age would actually do. The compensation needs to be reasonable, and there obviously needs to be some type of employer-employee relationship, right? In all these examples, there’s actually a business paying the kids. It’s not dad paying the kid to go to school, right? There’s a business paying the kids to sweep the floors or shovel snow or order, deliver groceries, right? You need to have a business.
This case is interesting. Eller v. Commissioner, it’s a 1977 cases. This guy was a trailer park owner, and he paid his kids. They did stuff around the trailer park. They were 12, 11 and seven. So, this is an interesting case, they performed a variety of services for their parents’ business after school, weekends, during the summer vacations. They were necessary for the operation of the business; could not have been performed by the existing staff, that’s another important factor. Are the things you’re paying your kids, could someone else in the business do it or this is really a real job, right? Real services are being performed; it’s not paying to answer the phone when you have six receptionists that could do it and the phone doesn’t ring. The various mobile parks children were signed a variety of responsibility, including maintenance of swimming pool, landscaping park grounds, they did all kinds of work. And the Court held that “whether the amounts paid as compensation are reasonable and represent payments purely for services or questions of fact to resolve on the basis of all the surrounding facts and circumstances, the burden of proof, of course, is on the taxpayer.” And then the Court presented an interesting position on the age of the children. The Court said, “our findings differ somewhat from the amounts deducted by the petitioner for two reasons. First, we think that reasonable value of John’s service must reflect the age differential between him and his brother and sister. John was seven, Michael and Patty were twelve and eleven. Experience teaches that eleven and twelve year-old children can generally handle greater responsibility and perform greater service than a seven-year old. Moreover, was testified the practice to promote youngsters as they demonstrated their aptitude, acquired, experience, developed some greater responsibility. Second, we think that there should be some relationship between the reasonable value of the children’s service over the three year period. After all, the record does not indicate that the children rendered significantly greater services over this time.”
So, in a nutshell, here are some things to consider. The wages paid by the parents to child must be for actual rendered services. If it’s not in a business, I would suggest not paying it from a parent to child. If it’s in a business, it needs to be reasonable. It needs to actually be service that’s bona fide, that’s performed, that cannot be performed by a person that’s already employed. The age matters, right? What you pay a 15-yearold is going to be different than what you pay a six-year old or a three-year old or a twelve-year old, okay? So, age matters. Compensation matters, based off service performed and age. Seven-year old can’t perform the same work as a 16-year old and shouldn’t be paid the same. It’s up to the parents or the business to justify the compensation, okay?
So, what does this all mean? Means there’s no hard, black or white line. It’s a lot of gray. As the case says, and as all these rulings and case laws suggest, facts and circumstances matter. What’s the service performed, what’s the compensation, the age of the kids, what are they doing? Can you prove that they’re actually doing the work? So, can you pay potentially a four-year old to do work? Yeah, I mean, I have a neighbor, their child is a child model for baby products. Another friend is in the baby business and their kids do modeling. Another kid models for Ralph Lauren. It’s possible. Okay?
But, if you don’t have those situations and you have a small business paying a four-year old kid and saying they’re answering the phone or they’re doing emails or marketing is super risky. And what happens, right? What happens if you lie and they get caught? Well, basically, there’s an excise tax, right? Because you contribute to a Roth that you didn’t have income for. You’re talking about a 6% excise tax, maybe some penalties, but definitely an excise tax. You got to pull everything out and potentially pay tax on any of the earnings that the Roth generated. So it’s not a life or death thing. You’re not going to jail. It’s not a 40% tax. There’s an excise tax.
But at the same time, you don’t want to push the envelope too far. But if there’s bona fide services, real compensation, you can prove that the kid is doing the work, you have a business, even better, or if it’s a non-parent paying the kid, have proof, right? You want to have some records of compensation. Now, electronically, whether it’s Venmo, Zelle, Bitcoin, there’s proof of money being transferred, but it’d be nice to have some proof that the service was performed, too. I’m not saying a kid needs to invoice their neighbor for basketball coach or to provide math tutoring. Why? Because a lot of times the kids don’t report the income, right? There’s a lot of times where kids, minors will do some basketball coaching or tutoring or consulting for a neighbor, and they just pocket the money and spend it. That’s cool, but you can’t put it in a Roth IRA if you don’t report it.
So, how do you report income? How does a kid report income? So, basically, the kid, in most cases, if it’s earned income over $1,150 well, let me start from here. A dependent child, so anyone, a child that lives with you, and they earn more than $12,950, they need to file their own tax return, okay? Obviously, earned income includes wages and tips. If a kid, the dependent child receives more than $1,150 in investment income, they have to file a tax return. If the investment income only is of interest dividends, they can just file 8814 and you can attach it to their tax return.
So, the $12,950, they would file their own tax return, if they have above that. If they have under that, you can report their income on your return. And if the kid has $1,150 of investment income, they would need to file their own return, but if it’s only interest and dividends, they can just file an 8814 and put on your return.
Okay, so the $12,950 is the number. Most kids are going to earn less than $12,950. For Roth IRA purposes, it’s really $6,500, right? That’s the golden ticket. You want to have at least that amount so you can put in a Roth, okay? And it’s just about reporting it. So, there’s a kid doing work around the neighborhood for friends or small businesses, you actually may want to have them report the income. Yes, you’re going to have to pay some tax on it. They can do a pretax IRA, but they can also do a Roth, and based off the examples I mentioned, having a Roth IRA is super advantageous, especially if you can start at a super young age, right? Whether it’s 12, 14, 15, 18 matters. Every contribution at that age has enormous six figure benefits as you get older.
So, let’s put it all together. I can’t tell you if you can open a Roth IRA for your kid. I know that’s the lawyer answer in me, but it’s the truth. It’s facts and circumstances-specific. But remember these things. Number one, it helps if you have an employer-employee relationship, if you have a business, pay your child. If you’re just paying your kid from a parent to child, I would not do it. Too risky. Have a neighbor, a non-family member, non-dependent pay your child; doesn’t have to have an employer-employee relationship or business paying the kid. It could be babysitting, things like that.
If you are paying a child, whether parents’ companies paying the kid or a non-parent paying the kid, again, bona fide, real stuff, right? You’re not paying the kid to do nothing. Basic compensation, not paying the kid $75 an hour to do basketball coach; try to have some evidence that the work was done. So, if the kid’s working for you, get him an email, get her an email. Proof that the kid’s doing something. Have some work product, right on their computer, something to show that they’re actually doing something, if you get audited. If they can clock in, clock in; if not, just proof that they’ve done something. And then ultimately you want to make sure that this work was done. There was real bona fide services. Compensation was reasonable. No one else was doing the same work as the child and have evidence. And if you can do all that, then yeah, feel comfortable that you can do a Roth IRA. And the downside is if you do get in a situation where the IRS doesn’t believe you and questions the Roth IRA, you’re dealing with excise tax, which isn’t horrible, potentially some tax and penalties. Generally it doesn’t happen.
Why? IRS, if you looked at all these revenue rulings and cases, what do they all have in common? They’re all fighting over deductions. IRS doesn’t like fighting over Roths. Why? It’s after-tax. Not going to care, the kids not taking the money out for 50 years. They’re not going to fight you on it, generally. They could. They’re not generally going out. They’re going to fight you on deductions. Why? Because it lowers tax revenue, and that impacts the amount of tax they get in their pocket and they can spend. So, it’s very rare that you’re going to have the IRS go after Roth IRA contributions. Now, if it’s totally egregious and just really “clown life” like you’re paying a two-year old kid to be the CEO of your business, $100k. Like, they’re not stupid. But, as long as you have some facts, kid’s doing something, you can prove they’re doing something. Obviously, the older they are, the easier it is to prove. It’s easier to show that a 14-year old doing something than a two-year old, right? It’s common sense. You don’t want me to pay the kids $75,000 to just check some inventory or deliver groceries. Like, be smart about it. You really just want to get to the $6,500 number. That, to me, is the key. Smart about it, have facts. Just think about it from their perspective. The good news is they’re just not going to attack these type of transactions often because they’re not tax deductible. So, Roths are actually safer than pretax IRAs, which can reduce taxable income.
So that’s it. I hope you guys enjoyed today’s podcast, for watching on YouTube, appreciate it. Give it a like, if you don’t mind or subscribe. Otherwise, it’s an important topic. I try to do this every year. I like doing it. I’ve had Roth IRA with my kids. I haven’t done it every year, right? Some years, you just can’t do it. You have until April 15, 2023 for the ’22 taxable year. You still have time if you’re watching this, before April 15. But something you should think about, get some extra cash lying around, give it a shot. As my examples showed, six to seven figures for your kids when they’re older, and it could be $2 to $3 million if you do it right.
The last thing I’ll leave you is, let’s say you do this, this will blow you away. Let’s just say, you know what, let’s just say $5,500. Let’s just keep it conservative. $5,500 a year from 15 years old to 72, assuming an 8% rate of return, almost $5.9 million, okay? Let’s say instead of 15, started at twelve, $7.4 million. Even in 60 years, $7.4 million will be money. It’s not going to be $7.4 million, but it will still be worth a few million bucks based off time, value and money. And it’s free money, right? We’re talking about $5,500 contributions a year based off 8% rate of return. If you can juice it up to 9% rate of return, $11.6 million. So, contributions and returns matter. $330,000 of contributions from twelve to 72, $5,500 turns it to $11.6 million. There you go. I’m going to leave it at that. Numbers Don’t lie. Don’t trust me, Albert Einstein coined compounded returns the eight wonder of the world.
How do you do it? Do it in a Roth. You start early. Trust the process. Keep your good habits. You can have massive, massive tax-free wealth for your kid, just by helping them out at a young age. And you also teach them good lessons, good habits. So, that’s it. Have a wonderful, wonderful day. Thanks for listening. Thanks for watching. I really appreciate it. Thanks for all the support. Have a great week. Talk to everyone again next Wednesday. Be well.