By Dr. Jim Dahle, WCI Founder
A Roth IRA is a tax-free retirement account that boosts investment returns by lowering taxes when compared to a taxable brokerage investing account. It facilitates estate planning because it does not go through probate, stretches for up to ten years, and has no Required Minimum Distributions (RMDs). It is also a protected asset in bankruptcy in most states, providing substantial asset protection. As a tax-free account, a Roth IRA provides tax diversification in retirement and protects its owner from rising tax rates. Most people, including kids who are learning about finance, would love to have more money in a Roth IRA.
The problem is that it can be challenging to get a lot of money in there. Most of us are not Peter Thiel, who put shares of PayPal into his Roth IRA before it went public and ended up with $5 billion in his account. An individual can only contribute $6,500 ($7,500 if 50+) in 2023 into a Roth IRA, and high earners (MAGI > $153,000, $228,000 MFJ) have to jump through the hoops known as the Backdoor Roth IRA process just to get that. There are a few other techniques that can help boost Roth IRA holdings—including Roth 401(k), 403(b), and 457(b) rollovers into a Roth IRA; Spousal Roth IRAs; and Roth conversions. But most people still end up with less in a Roth IRA than they would prefer.
Perhaps getting started as early as possible is the solution. Maybe opening a Roth IRA for your kids is the answer.
Can I Open a Roth IRA for My Child?
If you were to open a Roth IRA for your kid, additional contributions and additional time to compound can really help down the road. There is no rule that you have to be an adult to contribute. You can start at age 0. Since a Roth IRA is a retirement account, however, you can only use earned income (by you or your spouse) to contribute to it. Passive income, portfolio income, and gifts are not allowed to be contributed to retirement accounts. While lots of wealthy people would love for their kids to start Roth IRAs at young ages, the hard part is to actually get them some earned income.
More information here:
How Kids Can Get Earned Income
It is pretty easy to identify money that cannot be contributed to a kid's Roth IRA. Here's a partial list:
Money That Cannot Be Contributed to a Child's Roth IRA
- Parental earnings
- Gift money (birthdays, holidays)
- Dividends, interest, rents (taxable but unearned income)
- Passive partnership income
- Chore money for household duties
- Unreasonably high salaries
What does that leave?
Money That Can Be Contributed to a Child's Roth IRA
- Reasonable earnings from a W-2 job where the company is owned by someone other than the parents
- Reasonable earnings from a W-2 job where the company is owned by the parents
- Self-employment earnings
- Reasonable household employee earnings from friends and neighbors (babysitting, lawn mowing)
As you can see, these sorts of earnings are pretty easy for a teenager but incredibly hard to do for an elementary-age child, much less a preschooler. Even if a teenager gets a job making $15 an hour, they still have to work $6,500/15 = 433 hours to max out a Roth IRA. That's a lot of hours, basically full-time all summer.
The other problem, of course, is if those kids bust their butts and work full-time all summer, the last thing they want to do with that money is put it away for the next 50 years until they retire. Luckily, money is fungible. That means you as the parent can give them money to spend on gas, movies, and clothes while they put their earned income into the Roth IRA.
Tax Issues with Roth IRA for a Child
One downside of kids earning money is that they also may have to file a tax return and even pay some taxes. While state requirements vary, the requirements to file a federal tax return (2022) are one of the following:
- Gross income of more than $12,550+ or
- Unearned income of $1,100+ or
- Gross income of more than the larger of $1,100 or earned income + $350 or
- Self-employment income of $400+
Note that just contributing to a Roth IRA does NOT mean a tax return has to be filed. Also, if your child is under 19 or a full-time student, you can file form 8814 with your return in lieu of them filing their own tax return, but only if their income is all unearned. So that's not going to help someone who is trying to fund a Roth IRA (where the income must be earned.)
Of those situations that allow a child to contribute to their own Roth IRA, two of them are much better than the others, mostly due to payroll taxes. If you are the employee of a business that is either a corporation or at least partially owned by someone besides your parents, you will have to pay payroll taxes (Social Security and Medicare.) If you are self-employed, you must pay both halves of the payroll taxes, even if you are a minor. Yes, technically even on lemonade stand kind of money. Luckily, most lemonade stands are not profitable if they actually took into account the cost of their supplies.
However, if you are a household employee and earned less than $2,300 from any one employer, those employers do not have to file Schedule H or withhold payroll taxes from you. And since you probably didn't earn more than $12,550 babysitting and lawn mowing, you don't have to file either.
The best tax situation for a minor child is to be employed by a business that is 100% owned by their parents and is not a corporation for tax purposes. Sole proprietorship or partnership: no problem. But an LLC filing as an S Corp? Payroll taxes must be paid for that child. There is an easy workaround, though. Simply start a sole proprietorship and have it employ your child. Then have the S Corp contract with the sole proprietorship for services.
Overpaying Your Child
The big temptation here, of course, is to overpay your kid from your own business. Every dollar you pay them is a deduction for the business. They won't pay either income or payroll taxes on it, and if it goes in a Roth IRA, they will never pay income tax on it. However, if you are paying more than a reasonable salary, the IRS is likely to come after you for it. You simply cannot pay your child $300 an hour to sweep the floor of your clinic when you could go out and hire somebody to do that for minimum wage.
It is natural to think of jobs that would command a higher hourly rate for your child to do. For very young children, there is little that can compare with modeling. ZipRecruiter says the 25th percentile for child models is $29,500, and the 75th percentile is $100,500. The internet suggests that hourly rates range from $25-150 per hour for child models. The IRS does not require you to make good business decisions, but if it is too ridiculous, it will be hard to defend in an audit.
Whatever you pay your child, you need to treat them like a real employee. That means filling out a W-4 and I-9 when you hire them, having signed contracts and timesheets, and filing forms W-2 and W-3 each year.
More information here:
Opening a Custodial Roth IRA Account at Vanguard
Physically opening the account is not particularly difficult. You basically do it the same way you open your own Roth IRA at Vanguard, Fidelity, or Schwab. A Roth IRA for a minor is a custodial Roth IRA and you cannot use it for your own purposes. It is their money. The accounts, however, all show up under your login. Once they are 18, they can have their own account and login.
Opening the account at Vanguard can be slightly more painful than opening your own Roth IRA account. Let me walk you through what is different.
First, log into your account. Then click on the “Open an Account” link at the very top.
Next, click the radio button next to “Open a new account with money from my bank” and hit “Continue.”
The next page is just informational, so you can just hit “Continue.” But note that you will need both the employer's address and your child's Social Security number.
Here is the tricky part. Instead of continuing through the form, go down that right-side column until you see the section that says “Accounts for minors” and click the link that says “Log in and complete an online form here.”
A new browser window will open, and it is pretty straightforward from there. Hit the “I accept” radio button and click “Continue.”
Another browser window opens, and you will see this form. Click the radio button labeled “Open a Vanguard Brokerage Account IRA,” click the radio button labeled “Yes,” and hit “Next.”
Click the radio button labeled “Open a Brokerage Roth IRA” and hit “Next.”
Click the radio button labeled “A minor” and hit “Next.”
At this point, you'll start entering the personal information about the minor. You'll then choose your role as the custodian and link it to a bank account. Note that you can link it to their bank account (probably the best practice), but these can also be funded directly from the business bank account or even your personal account. The IRS doesn't seem to care. I do it from the bank account of my children to keep the paper trail nice and clean in the event of an audit. Within a few days, you can start putting money into the Roth IRA and get it invested just like you would your own Roth IRA. As your kids get older, I would recommend reviewing their statements with them every quarter to teach them about investing. Given their age, you should probably invest pretty aggressively. To keep things simple, we use the latest Vanguard Target Retirement fund, but nobody would fault you for going 100% stocks instead.
Should You Open a Roth IRA for Your Child?
Now that we've covered the nuts and bolts, let's talk philosophy. There is no doubt that families managing money together across the generations can build wealth much faster than they each could individually. However, as many of us learned so well from The Millionaire Next Door, there is a price to be paid for giving your children too much support. Given the fungibility of money, you could let your kids spend your money (gifts) each year and use their money to max out Roth IRAs and 401(k)s. However, children who receive “Economic Outpatient Care” are less likely to build wealth on their own. It is a balancing act, and gifts must be accompanied by teaching. Even so, it will still have a negative effect on the work ethic of many people.
However, if you're all in on making your kids as wealthy as you can using your money, there are a couple of options that work pretty well even if you can't figure out a way for your kids to earn much money. These can also be done in addition to establishing a Roth IRA for them.
First, you can simply invest in your own taxable brokerage account and leave the money to them when you die. They will benefit from the step up in basis and inherit that money tax-free.
Second, you can open an UTMA/UGMA account, basically a taxable account for them that becomes their money at age 21 in most states. There is no limit on contributions to this account, although gift tax limits will apply and you need to understand them if you are wealthy enough to have an estate tax problem. Also be aware of the kiddie tax rules. They would suggest you invest an UGMA very tax-efficiently and that there is little point from an income tax perspective of having an UGMA much bigger than around $100,000 (the amount varies by the investment's yield).
Third, you could open a low-cost variable annuity for them. While earnings from this account will be taxed at ordinary income tax rates instead of long-term capital gains rates in retirement, the many decades of tax-protected compounding can make up for that additional tax and the fees of the annuity. This is a particularly good option if the investment you plan to invest in is very tax-inefficient.
Finally, if want to put conditions on receiving this money (and help protect it from future ex-spouses and other creditors), you can put it into a trust. The tax benefits are nowhere near as good as using one of these other accounts, but you will have a lot more control over the assets both before and after your death.
There are plenty of ways to make your kid rich. But only you can decide if you should or not, when you tell them that you have done so, and under what conditions it actually happens.
What do you think? Would you open or have you already opened a Roth IRA for your kid? Why or why not? Comment below!