Here’s the latest article from our own Adam Bergman that appeared on Forbes.com about setting up a Roth IRA for your child(ren) –
Numbers don’t lie. Anyone that has played around with a Roth IRA retirement calculator has probably been tempted to plug in some numbers based on the assumption that they started making contributions at a very young age. The ultimate tax-free number is always stunning. For example, if one starts a Roth IRA at age 10 and just contributes $1,200 a year from his or her summer job and continues up until the age of seventy, assuming an 8 percent rate of return, which is quite reasonable, that individual would have $1,624,164 tax-free. Pretty amazing stuff, which tends to lead to the next question – so why can’t I establish a Roth IRA for my children? Unfortunately, not everyone is able to do so.
Traditional and Roth IRAs allow you to save money for retirement. A Traditional IRA is a pre-tax retirement account that allow one to receive a tax deduction for the amount contributed, but distributions are subject to tax upon withdrawal, as well as an additional 10% percent penalty if the distribution is taken before the age of 59 1/2. Whereas, a Roth IRA is an after-tax account that does not offer a tax deduction for the contribution, but so long as the Roth IRA has been opened at least five years and the Roth IRA holder is at least 59 1/2 at the time of the distribution, no tax would be due. In addition, there is no requirement to take minimum distributions, as in the case of a pre-tax IRA. Hence, many retirement investors looking to secure tax-free retirement wealth generally turn to the Roth IRA.
When it comes to establishing an IRA, one must generally have earned income in order to be eligible to make a contribution. Earned income is generally defined as compensation for services, such as wages, salaries, commissions, and self-employment income. Passive income, such as capital gains, dividends, interest, and rental income is typically not considered earned income and, thus, is not eligible for contributions to an IRA.
In the case of children making IRA contributions, the key is that they must have earned income. Therefore, any compensation they earn either as an independent contractor or employee would be eligible to be contributed to an IRA. In general, there are three main items parents should consider when determining whether the income they paid their children for the performance of services would be eligible for contributions to an IRA:
1. Employment must be bona fide: In Rev. Rul. 72-23, 1972-1 CB 43, the question presented was whether wages paid by a father to his un-emancipated 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
2. Services must be performed in connection with a business activity: In the case, Lorraine Tucker, TC Memo 1979-449, the Tax Court held that a deduction was allowed for payments to a son where such payments were intended as compensation for services and were reasonable for services actually rendered. Lorraine Tucker operated a Drive-In Grocery in Houston, Texas, as a sole proprietorship. Ms. Tucker’s son, Jack T. Tucker, and his wife also assisted in the business. Her son assisted the business by ordering and buying all groceries, calculating the retail prices, shelving the goods, taking inventory and doing the bookkeeping. His wife assisted in the bookkeeping by preparing daily cashier’s reports and sales summaries and writing some of the checks to pay the bills. The IRS questioned the business deductions she took for the years in question. The Tax Court held that Ms. Tucker was entitled to deduct, as ordinary and necessary business expenses, reasonable compensation paid to her son as her son had generated earned income.
3. Amount of compensation must be in line with services performed: In Rev. Rul. 73-393, 1973-2 CB 33, the IRS held that reasonable wages paid by a father to his child for services rendered as a bona fide employee in his trade or business are deductible business expenses, even though the child used the wages for part of his own support.
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
So what does all this really mean? Essentially, if you want to be able to pay your children so that they can contribute to a Roth IRA you are really going to have make sure your children are doing real bona fide work in connection for real services rendered to your business. The services performed must be real, the compensation must be reasonable, and the services must be performed as part of a business relationship and not for personal services, such as home chores. Hence, if you are retired, disabled, or have a full-time or part-time job that does not offer you the opportunity to generate any self-employment or business income, the only way your children will be able to generate earned income that would be eligible to be contributed to an IRA is through employment or independent contractor related services performed for a third-party business.