In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the advantages of starting a Roth IRA for your kids and how to do it.
Hey everyone and welcome to another episode of Adam Talks. I’m Adam Bergman, tax attorney and founder of IRA Financial. Today’s episode: Opening a Roth IRA for your Kids. Can you do it? Should you do it? What are the rules? How it works. What do you got to think about?
So, this is a really important topic, something that I like to talk about generally prior to April 15, because April 15 is the date that you have to make contributions to an IRA for the previous year, in this case, 2021. So this is a good time to start thinking about whether you can make IRA or, specifically, Roth IRA contributions for your kid. So why would you want to do that?
Well, number one, the Roth IRA is super tax advantageous. Why? So long as you’re over 59 1/2 and the Roth has been open at least five years, you can pull all the Roth IRA money out tax free. So if you’re someone who’s 12 or 15 or 17 years old and you can start putting away money in a Roth and have 30, 40, 50 years of tax-free growth, compounding returns. Some pretty exciting stuff.
Albert Einstein said compounding returns is the 8th wonder of the world. In sum, your funds should double every eight years if you can average an 8% rate of return. So, starting early has an enormous benefit for retirement investors. Take it from me as a tax lawyer, if I was able to make Roth IRA contributions; well, actually, the Roth IRA started 1997, so I was already 22 years old when the Roth IRA is created.
But I have two kids, eleven and eight. And if I was able to do Roth IRA contributions for them, and I have, imagine how much potential money they can have when they’re in their 60s. Right? The numbers are super exciting. So a lot of people say, hey, Adam, “can I open a Roth IRA for my kids?”
So the first question is it comes down to maybe. Like every good lawyer, the maybe is, does your child have earned income? And earned income does not mean interest, dividends, royalties, rental income, capital gain. It means compensation for services or some type of business income, whether it’s your child selling a widget, Yeezys or Dunks on eBay, or they’re drawing pictures and selling on Etsy or designing clothes, or they are performing services, like serving as a model on a website for children’s clothes. That’s actually what my sister did when she was younger. Too bad there were no Roth IRAs then. Also, a lot of clients where their kids are camp counselors or they do babysitting or they are lifeguards. They teach basketball.
I have a neighbor who after school for a couple of hours a day. He has a group of kids. Grade one, grade two. Basically, just some light basketball coaching, more like babysitting and he does pretty well. He charges $20 a kid. He usually has five to ten kids a session and he’s banking it. He’s making some good cash. So I talked to him. He’s in high school. I said, hey, buddy, you should set up a Roth IRA. He’s like, yeah, I will. It’s pretty good. I use some of the money to go out, go to movies, pay for streaming services, buy myself some new shoes. But I have some extra cash and, yeah, I should totally put it into a Roth IRA.
So I wanted to just highlight a couple of cases and some revenue rulings that I think demonstrate what the IRS is looking at in terms of whether someone has earned income, specifically in a parent-child dynamic.
So, I’ll just kind of go through a few; it’s not going to be a full case review, so don’t worry, it’s not going to be like first-year law student. But I just want to highlight a couple, so you get an idea what the IRS is looking at. And some of the revenue rulings are quite old.
So this one’s from ’72 revenue Ring 72-23. This ruling, the question presented was whether wages paid by a father to an unaccompanied minor child for personal services rendered is a bona fide employee with deductible. And this is what the ruling said, this is pretty important. Where the facts show that an actual service was rendered by a taxpayer’s child as a bona fide employee in the operation of the taxpayer’s business and that the competition paid for such services is reasonable and constitute an ordinary, necessary expense of carrying on such business, such wage payments are deductible.
So basically, let’s kind of deconstruct this. Number one it’s got to be an actual service, right? You can’t just sit on the couch and get paid. Number two, there needs to be some type of bona fide employee-employer relationship between the parent and child. Now, I’m mentioning parent and child.
If your child is getting paid through a neighbor, or a third party, that is different than the parent-child. And that probably has less scrutiny from the IRS than if the mom or dad is paying the child. Okay, so the mom and dad are paying the child. Number one is going to be actual services. Number two, you’re probably going to have to have a business paying the child.
The dad or the mom just can’t pay the kids to go to school or to mow the lawn or to clean the car. It’s got to be, hey, I have a business and I’m paying you to sweep the floors or fix the equipment or work on the website. Whatever it is, the employer-employee relationship is important when you get into the parent-child context. If there’s no parent-child dynamic, then you can have some more flexibility and you can obviously pay the child to do a more menial, less employer-employee type work, like mowing the lawn or watching your kids or cleaning the fence or painting the walls.
Things like that do have more substance if it’s not in a parent-child dynamic. Next case, this is Lorraine Tucker. It’s a tax court memo, 1979. In this case, the court held a deduction was allowed for payments to the son. In this case, the individual, she had a grocery store and she was actually paying the son, who had some experience to help with inventory and do some grocery-related activity.
And there the court said, there was actual services. It was reasonable paid, and it was in an employer-employee contact. So it wasn’t just the mom paying the kids, “hey, if you get an A on your test, I’m going to give you $100.” That wasn’t it. Here the son was actually performing real services for the business.
The next one is a taxpayer memo, 1974, Fermanski. This guy was a doctor and he paid his son or he paid several children to do either research and also to fix the equipment. And in this case, the court said, well, you can’t pay your kids for research because they’re not qualified; they’re not doctors. And they actually went into the age of the children was relevant versus, in other cases. So that’s interesting as well. They actually looked at the age, but they said the research wasn’t an actual reasonable salary or service because they weren’t qualified. But the kids were able to fix the equipment. And in that case, they felt it was a real employer-employee relationship. A bona fide service was performed and they accepted the compensation and allowed for the deduction.
So again, when there’s a child-parent relationship, number one, you want to make sure it’s real service and it should be in an employer-employee context, not just paying your kid randomly to do work.
Another one, Revenue Ruling 73-393. In this ruling, reasonable wages paid by a father to his child in a trad or business were deductible where the child uses the wages for their own support. So again, it was an employer-employee relationship.
Next one, Nathaniel Denman. It’s a tax court case. And in this case, they held that the deduction was allowed; reasonable amount was paid, and the child performed light duties relating to an engineer individual’s business. But again, it was real services. There was an employee-employer relationship, and this conversation was reasonable. Three important factors.
Again, if you notice in all these cases, there’s an employer-employee relationship, it’s not just randomly paying your kid to do some homework, which is not going to fly.
Next one, Eller v. Commissioner, 1977 case; this guy, he was a trailer park owner and he paid the kids and there’s multiple kids here, 12, 11 and seven to do various tasks around the trailer park. And in this case, as some of the others I mentioned, they looked at the age of the children, the services being performed, the reasonableness of the actual salary to determine whether the deduction was allowed or not. So all in all, super important.
So you may be saying, okay, I kind of understand this kind of feel like I just went to law school. Law school is actually way more boring than what I just did. I summarized all the cases; you actually don’t have to read the cases, but a couple of things. If you’re paying your kids, you should make sure it’s real services and it’s an employer-employee relationship. You’re not just paying your kids randomly to play video games or even to mow the lawn. There’s no employer-employee relationship.
It’s probably not going to fly. It’s not going to be treated as earned income. Your neighbor, your friend, nonlineal descendants do that. I think you’re good. Even if you’re an aunt, uncle, cousin paying the kids to do babysitting, things like that, that’s going to fly because that’s not a parent-child relationship.
If your kids have their own business, even if it’s $1,000, selling stuff on eBay, that works. Okay, it’s real income. Now, if you say your kid has a business but they’re only client of you and you’re paying them for “consulting services,” probably not going to work right? You want to make it a third-party that’s providing the income to your child, like a friend, neighbor, or just a random consumer buying the product on the Internet.
When do the kids have to file tax returns?
Okay, so this is interesting. If it’s non-earned income, like interest dividend, if it’s over $2,200, they’re going to have to file their own tax return. If it’s earned income, meaning performance of services. If it’s over $12,550, they’re a dependent – they have to file their own return. Otherwise you can have them as a dependent and you can have the income on your return. Just report it on your return. They don’t need their own tax return. So there’s a distinction between earned and unearned.
So bottom line here, if you have a kid, obviously if your kid is two years old, three years old, other than doing some baby clothes modeling or, I actually have a neighbor, who, the kid was hired to do, the kid was actually on TV for some baby product. That can fly. But like paying your three year old to repair your equipment and your business or do things like that, it’s just a joke. It’s not going to work if you get audited, the IRS will invalidate it. So just be cautious. I think once the kids over 10, 11, I think you have some flexibility.
Obviously, babysitting, camp counselor is not going to work at 10,11, but helping out, things like that, for a non-parent paying the kid, that can work. Again, if your kids selling stuff on eBay at ten or eleven, God bless them. They’re probably going to be smarter and more successful than all of us. But you’ve got to be cautious of the age, the reasonableness of salary, the actual services being performed, and be careful and make sure that there’s an actual employer-employee relationship.
If you satisfy and check all those boxes, then go for it. Even if it’s under $12,550, even if the kid puts away $500, $1,000, that money in the next 30, 40 years will probably be worth $40, $50,000. I mean, seriously, especially if they’re doing good investments, there’s a real chance that that could be some serious money in the next 40 or 50 years. Also, it starts them, good habits, right? Saving. Whether they put it in a Roth IRA or just put in a savings account, you’re teaching your kids good habits to save, which we all can appreciate.
So I think there’s some real benefits; just got to be cautious and don’t get too aggressive. Number one, again, employer-employee relationship. If it’s non-parent paying a child, there’s some more flexibility. And obviously, if there’s an employer-employee relationship, if you’re paying the child, you want to make sure they’re treating it as competition. The business is treating as a deductible expense. If it’s earned income, under $12,550, kid doesn’t have to file his or her own tax return; over that, they do. And for unearned income, over the $2,200, they’re going to have to file their own income tax and probably pay a kiddie tax.
So there you go, it’s not super complicated. It’s common sense, right? If it’s actual services, bona fide, it’s reasonable. You’re not paying your eight year old kid $6,000 for babysitting three times a year. Just got to be careful, not to say the IRS will kind of scrutinize this. Most of the cases and rulings, if you notice, actually come down on the business, right.?
The kids don’t get audited and the individual tax return, it’s really not significant. What happens is the business gets audited, and then the IRS auditor says, wait, you pay this person $5,000 or $6,000, they’re your kid. Now, let’s see if it’s bona fide.
It’s not that difficult, right? They look at last names, they’ll look at your payroll. They’ll look at your independent contractor list, they’ll see expenses, they’ll see Jones and Jones. Hey, Jones, you paid this person Dan Jones. Dan Jones. Oh, he’s my seven year old kid.
Well you paid him $7,000 last year. What did he do? And that’s when it starts. So you just got to be cautious, make sure it’s actual bona fide and reasonable. And there’s an employer-employee relationship.
That’s all good stuff. And at that point, your kid should be able to go Roth. And hopefully in the next 40 years or so, they will be super happy you did that. And hopefully you’re teaching them a good lesson. And there’s consistency.
And they now trust the process of saving for retirement so they can start doing it themselves as they go through college and get their first job and then get their feet wet in the employment world; they’re going to be taught the right way to save, whether it’s through a Roth IRA or 401(k) plan. They’ll understand the power of the retirement system, the power of deferral, power of compounding returns and will be set up going forward to reap the benefits of the retirement saving regime that we all live under.
So, there you go. I hope you guys enjoyed it. I know I did. Not sure I’m going to be able to pay my kids this year. I don’t think they’ve done enough work for me and they’ve been too busy playing video games and playing sports so I’m not sure it’s going to work out for them this year. But, as my kids get older I promised my wife that they will be working, whether it’s at a local grocery store. They’re going to learn the power of hard work and also hopefully benefit from taking some of that money and putting it in a Roth IRA which will ultimately benefit them down the road.
So, I appreciate you guys listening and watching if you’re on YouTube, subscribe, if you haven’t already, and definitely check me back every Wednesday. Two other podcasts, AdBits and Admail, which are weekly podcasts if you’re interested in self-directed retirement topics. Admail is super fun – go through three of the best questions from clients each week, and AdBits will give you a “bit” of information on specific self-directed retirement topics so definitely remember to check them out. Otherwise have a great week and, talk to everyone again next week. Take care!