The ability to start a Roth IRA for your child largely hinges on whether or not he or she has any sources of earned income. For individuals who have a business and the ability to pay their children for real business-related work, starting a Roth IRA for a child could be a viable option. If you don’t have your own business, paying your own child is likely not very realistic. You would need to wait until he or she is able to go out on his/her own to receive earned income.
- The Roth IRA is arguable the most powerful savings tool for the young
- You can start a Roth for your child, but only if he or she has bona fide earned income
- So long as there’s earned income, the Roth contribution can come from any source
The Power of the Roth IRA
The secret sauce to generating tax-free wealth at retirement starts with the Roth IRA. Mix in some time and patience, and you have a recipe for success. All investments held inside the plan grow tax free. You never have to worry about paying taxes on your qualified Roth withdrawals. To that end, any Roth IRA must have been opened at least five years (no problem in this scenario) and the account holder must be at least age 59 1/2 (that’s where the patience comes in).
Unlike a traditional plan, which is funded with pretax money, a Roth is funded with after-tax money. There’s no upfront deduction with a Roth, but that’s not even worth it for a child with a part-time job anyway.
The earlier the Roth IRA is established and funded, the longer the IRA can grow without tax. For example, if one established an IRA for his or her 15 year old, and $2,000 was contributed to it every year until age 70, and earned an annual rate of return of 7.5%, the Roth would be worth about $1.5 million, all tax free! Whereas, if all the above was true except that the IRA was started at age 35, it would only be worth approximately $330,000.
Related: Importance of Investment Diversification
Starting a Roth IRA for your Child
Starting a Roth IRA with any IRA custodian is easier than ever. For example, one could simply go to the IRA Financial app and complete some basic information on the child to open the plan. The process only takes a few minutes.
Once the account has been opened, the funds earned by the child can be contributed to the plan. Technically, the funds can come from any source, such as yourself, your child or a family member. The key is that the child actually earned the funds in the year in question. Roth IRA contributions are not tax-deductible, so they will have no impact on the parent or child’s tax return.
The Roth IRA & Child Compensation Rules
In order to pay a child income for the performance of services, the services must actually be performed in the context of a bona fide business relationship and the compensation must be reasonable. In other words, if you do not have a business, you will likely not be able to pay your child(ren) for services performed. That doesn’t mean that your children will not be able to contribute to an IRA, it just means that the income they earn must come from another business, such as a grocery store, camp or restaurant.
Paying your child to clean their room, do their homework, or walk your dog will not satisfy the definition of a bona fide employee-employer relationship.
Revenue Ruling 72-23, 1972-1 CB 43
Below is an example that provides guidance on how the IRS looks at an employee-employer relationship involving a child.
In this revenue ruling, the question presented was whether wages paid by a father to his unemancipated minor child for personal services rendered as a bona fide employee were deductible as ordinary and necessary expenses for Federal income tax purposes. The ruling stated:
“Where the facts show that actual services are rendered by a taxpayer’s child as a bona fide employee in the operation of the taxpayer’s business, and that the compensation paid for such services is reasonable and constitutes an ordinary and necessary expense of carrying on such business, such wage payments are deductible as a business expense for Federal income tax purposes..”
In sum, the ruling held that the child generated bona fide earned income, thus, the funds could be contributed to an IRA and the business was able to deduct the compensation paid as a business expense.
Overall, the IRS and courts are essentially saying that for you to pay your child for services rendered, several factors must be present:
- The wages paid by the parent to the child must be for services actually rendered as a bona fide employee in the conduct of a trade or business, or in the production of income.
- The compensation must be reasonable and in line with the type of services performed.
- The age of the children and the type of services performed, and compensation generated are all relevant.
- The compensation must be for a bona fide employer-employee relationship and not a personal allowance.
- It is up to the parents to justify and prove that the compensation paid for the services performed by the children was bona fide, reasonable, and associated with a trade or business, or in the production of income.
Starting a Roth IRA for a child is actually quite simple. The tricky part is figuring out if he or she has bona fide earned income to be eligible to contribute to the plan. This is easier when your child works for someone else and receives a paycheck. However, if you want to start them younger, you need to tread carefully. The IRS will scrutinize an account that looks fishy. It’s best to avoid starting an IRA prematurely.
As we mentioned, if you have your own business that your child can work at, say busing tables, stocking shelves, or stuffing envelopes, so long as you pay them an appropriate wage for doing so, you should be good to go.
Obviously, if your child is too young to work, it’s still important to educate them about finances. Start them off with a “play” Roth IRA, and show them how their pennies will grow into dollars. The sooner you start, the more prepared your children will be when it comes time to save!