Funding a 3-Year-Old’s Roth IRA

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My husband is an aspiring permaculture farmer in addition to a stay-at-home father. One day, he hopes to have our 1-acre lot furnished with beautiful edible landscaping that he can use as a market garden. Right now though, we are in the early stages. Much of the work is simple tasks: picking up sticks, spreading compost, planting, and weeding.

This past year, my daughter turned three years old, and my husband realized that she had come into her own as a useful farmhand. She was trustworthy to stay in our yard without extreme supervision, treated basic farm tools with care, and performed many simple tasks independently.

In October at the end of the growing season as he was getting his garden bed ready for winter, he offered to pay her one cent per weed she pulled. He gave her specific instructions — how to pull out the weeds, where to put them for counting, where and how to compost them after counting, and more.

In this way, my daughter was employed at her first job, earned her first income, and was able to fund her Roth IRA for the first time.

1. Pay the Household Employee

Although it is a little known fact, household work such as this does indeed qualify as earned income, even if the employer is the child’s parents.

As a parent-employed minor, my daughter is allowed to “work for a business owned entirely by your parents as long as it is not in mining, manufacturing, or any of the 17 hazardous occupations” at any age. Also, you are not required to withhold federal income tax from wages you pay to a household employee, and, as the IRS states in its page on “Family Help ,” wages earned from a parent employer to an under-age-18 child employee are not subject to the FICA taxes of Social Security and Medicare. Plus, you only need to file a federal tax return for your child if the regular IRS rules for filing require them to file. (See Publication 929, Tax Rules for Children and Dependents for information on this.) This makes employing your child in household tasks a breeze.

Whenever engaging in anything IRS related, the best protection is good records. Each time your child does a job, the best advice is to save and record:

  • When and/or for how long the child worked,
  • What task they were doing,
  • How much they were paid,
  • When you paid them, and
  • How much of their pay was in cash.

Because my husband (who dislikes paperwork) is employing my daughter the most, I made a very simple Word Document pay stub for him to fill out that I am happy to share. Here it is as a Word Document (in case you want to customize it) and here it is as a PDF.

The IRS says you need to “Keep your employment tax records for at least four years after the due date of the return on which you report the taxes or the date the taxes were paid, whichever is later.” However, we recommend keeping your records basically forever.

In 2019, my daughter earned $1.70 from her weed collection. We elected to pay my daughter in coins directly to her wallet (a zippered coin purse) on the date of her work. However, you can separate the date of employment and the date of payment, just as any other employer can do, by paying monthly, at the end of the week, or some other pay period.

Our financial lessons with our daughter at this point are impulse control (“Let’s wait a week.“), opportunity cost (“If you buy that, you can’t buy…“), and the value of hard work. To engage in those discussions, we decided it was best for her to have the money right after working.

2. Open a Custodial Roth IRA

Once your child has earned the income, then your child is eligible for an amount of Roth IRA funding.

The first step is to open the Roth IRA.

I opened my daughter’s Custodial Roth IRA at Charles Schwab, because that is where my other finances are held. At Charles Schwab, you can open a Custodial Roth IRA with a $0 minimum deposit and $0 online equity trade commissions. To open the account, you use the “Custodial / Minor IRA Application.”

In Section 1, you select Roth Custodial IRA. Section 2 is for the child’s information and Section 3 is where you fill out the adult custodian’s information, normally one of the guardians.

In Section 2, it asks about your child’s employment. We elected to bubble the box for “student” but then also fill out the employer information. We did “Household Employee” as the employer name and bubbled other with a description of “Yard and House Cleaning Worker” for Occupation.

In Section 4, you get to select the age of termination. Your options are normally either age 18 or age 21. We elected to use age 21 because as the custodian I can always distribute the funds to an individual account for my daughter earlier than the age of termination, but once she reaches the age we have set we cannot easily pull the funds back into a custodial account.

In Section 10, you can set a successor custodian. This section requires someone to witness your signature. I elected to name my husband as my successor custodian and, out of laziness, also used him as my witness. This strategy was likely less than ideal and I probably should have gotten someone else to witness it, but Schwab processed the paperwork and I cannot imagine anyone will challenge the other parent as the successor.

3. Fund the Roth

There are many ways to fund a child’s Roth account.

Unlike a 401(k) plan, which requires salary deferrals in order to fund, you or anyone else can fund a Roth IRA with any money. The child can contribute. Parents can contribute. Grandparents can contribute. A random friend can contribute. The only hitch is that you are limited in how much you can contribute up to their earned income or this year’s IRA contribution limit whichever is smaller.

If you want to maximize the amount that is put in while still giving the child a choice, one clever suggestion is that you or a grandparent could offer a Roth contribution match as a gift. For example, every dollar the child contributes, you promise to also contribute one dollar. In this way, the child can save half of all their earnings as spending money while still getting the full allowable amount into their Roth IRA to grow tax-free. This also provides early exposure to a real conversation they will have later in life when they are offered an employer match and asked how much they want to contribute to their 401(k) plan.

Because we paid her directly and her earnings for 2019 only amounted to $1.70, we decided to fund her Roth IRA by gifting her $1.70 from our own funds.

Although you can do this using a “Check and Journal Request Form,” if you have an online login or use a banking mobile app, you can transfer funds easily online. For instructions on how to do this at Schwab, follow “How to Fund Your Roth By Using Another Schwab Account.”

4. Invest the Contribution

The easiest way to invest $1.70 is to buy a mutual fund. Although there are many advantages of ETFs over mutual funds, most custodians do not yet allow fractional trading (purchasing less than one share). For this reason, you cannot invest small sums like $1.70 in an ETF as one share almost always costs significantly more than $2.

In contrast, mutual funds allow you to buy a specific dollar amount, even a dollar amount as small as $1.70, because the managers will simply pool your assets into their invested assets and make their purchases accordingly.

Although custodians like Charles Schwab have moved to transaction-free online trading for all ETFs, mutual fund purchases still often carry a large transaction fee (currently up to $49.95 per purchase at Schwab). That being said, most custodians have a short list of no-transaction-fee mutual funds where the fee on the purchase is $0. Obviously, when investing a small sum like $1.70, we would need to shop only from the no-transaction-fee list as any transaction fee would decimate the small amount we are trying to invest.

Both emerging markets and small cap value are very volatile but also have a high expected return. For this reason, they make great investments when you have a long time horizon. Because my daughter is only three now, she has likely one of the largest time horizons of any investor. As a result, my ideal purchases would be (in this order):

  1. Emerging markets like Vanguard Emerging Mkts Stock Idx I Inv/Adm (VEIEX/VEMAX)
  2. Small cap value like Vanguard Small Cap Value Index Inv/Adm (VISVX/VSIAX)
  3. Mid cap value like Vanguard Mid-Cap Value Index Inv/Adm (VMVIX/VMVAX)
  4. Large cap in the S&P 500 like Vanguard 500 Index Inv/Adm (VFINX/VFIAX)

These specific funds would be great purchases for someone with the account held at Vanguard, where Vanguard mutual funds are no-transaction-fee. However, I am limited by which funds are no-transaction-fee at Charles Schwab.

At Charles Schwab, the no-transaction-fee mutual fund list is called the “Schwab Mutual Fund OneSource.” That list contains all of the Schwab mutual funds as well as a few other funds. There are 162 mutual funds on that list with an expense ratio <0.5%, but only 11 with an expense ration <0.1%. Because low expense ratios are better predictors of performance than even Morningstar stars, I elected to only look at the list of the 11 cheapest. (Though I did peek to see if they had a great emerging market or small cap value fund on the list, but they did not.)

The list of 11 cheap funds are:

Symbol Description Expense Ratio
SWPPX Schwab® S&P 500 Index Fund 0.02%
SWTSX Schwab Total Stock Market Index Fund® 0.03%
SWLGX Schwab ® U.S. Large-Cap Growth Index Fund 0.04%
SWLVX Schwab ® U.S. Large-Cap Value Index Fund 0.04%
SWAGX Schwab U.S. Aggregate Bond Index Fund 0.04%
SWMCX Schwab ® U.S. Mid-Cap Index Fund 0.04%
SWSSX Schwab Small Cap Index Fund® 0.04%
SNXFX Schwab 1000 Index® Fund 0.05%
SWRSX Schwab® Treasury Inflation Protected Securities Index Fund 0.05%
SWISX Schwab International Index Fund® 0.06%
SWSBX Schwab Short-Term Bond Index Fund 0.06%

 

Because they don’t have emerging markets (only all world), small cap value (only small cap total), or mid cap value (only mid cap total), my next choice would be to invest in the S&P 500.

For this reason, I invested the whole $1.70 in Schwab® S&P 500 Index Fund (SWPPX). I’m fairly satisfied with this purchase. After all, an expense ratio of 0.02% is hard to beat!

5. Tax Return Filing?

The next matter to handle is if a tax return needs to be filed. Publication 501 “Dependents, Standard Deduction, and Filing Information” states:

A person who is a dependent may still have to file a return. It depends on his or her earned income, unearned income, and gross income. For details, see Table 2. A dependent must also file if one of the situations described in Table 3 applies.

Table 2 states, for those who are not blind:

You must file a return if any of the following apply.

  • Your unearned income was more than $1,100.
  • Your earned income was more than $12,200.
  • Your gross income was more than the larger of—
    • $1,100, or
    • Your earned income (up to $11,850) plus $350.

The $12,200 earned-income-only limit comes from the standard deduction. The idea is that the child will not owe tax if their taxable income is less than the standard deduction, so you need not file a tax return.

The $1,100 limit for unearned income is from the so-called kiddie tax or Form 8615 “Tax for Certain Children Who Have Unearned Income.” Because unearned income may be taxed at the parent’s tax rates if it is over $1,100, you must file the child’s tax return and Form 8615 if unearned income exceeds this limit.

The publication goes on to make clear that there are a few other cases you may want to file, such as:

Even if you don’t have to file, you should file a tax return if you can get money back. For example, you should file if one of the following applies.

  • You had income tax withheld from your pay.
  • You made estimated tax payments for the year or had any of your overpayment for last year applied to this year’s estimated tax.
  • You qualify for the earned income credit. See Pub. 596 for more information.
  • You qualify for the additional child tax credit. See the Instructions for Form 1040 and 1040-SR for more information.
  • You qualify for the refundable American opportunity education credit. See Form 8863.
  • You qualify for the health coverage tax credit. For information on this credit, see Form 8885.
  • You qualify for the credit for federal tax on fuels. See Form 4136.

This list likely does not have anything your child can take advantage of. Most child household employees should not have withholding or estimated payments. A requirement of the earned income credit is that “You cannot be a qualifying child of another person,” which would apply if you are filing for the child tax credit. Your minor likely does not have a child of their own, so no child tax credit. The refundable American opportunity education credit is for those in college. You are not eligible for the health coverage tax credit if you can be claimed as a dependent on another person’s federal income tax return. And your minor likely does not qualify for the alternative fuel credit.

Table 3 is “Other Situations When You Must File a Return” which states “If any of the seven conditions listed below applied to you for 2019, you must file a return.”

The ones that are worth addressing for minors are:

1. You owe any special taxes, including any of the following.
… c. Social security or Medicare tax on tips you didn’t report to your employer (see Pub. 531) or on wages you received from an employer who didn’t withhold these taxes (see Form 8919).
…e. Household employment taxes. But if you are filing a return only because you owe these taxes, you can file Schedule H (Form 1040 or 1040-SR) by itself.
…3. You had net earnings from self-employment of at least $400. (See Schedule SE (Form 1040 or 1040-SR) and its instructions.)

Wages earned from their parent employer to an under-age-18 child employee are not subject to the FICA taxes of Social Security and Medicare. However, if household wages from a non-parent or to an older child are $2,100 or more during the year, then FICA taxes are necessary. Thus, reason 1(c) would not apply to a parent-employed child but may apply if your child is either older or working for other households.

Reason 1(e) of household employment taxes is a red herring I thought was worth addressing. Household employment taxes are for an employer who is trying to pay and report FICA taxes for your employees. Your minor does not need to file this (they are an employee) and you likely do not need to file Schedule H if you are employing your own child because parents are usually exempt from FICA.

Reason 3 is another red herring. A household employee is not self-employed. Self-employment is only if your minor is an independent contractor.

From all of this analysis, you can see that the gross income test is really the main test of importance for the average family.

In my daughter’s case, she has an UGMA funded by great-grandparent gifts that generates a small amount of unearned income. In 2019, her total ordinary dividends from this account was $40.03 with $0.25 of capital gains for a total unearned income of $40.28. Her gross income is then $40.28 + $1.70 or $41.98 for 2019. The rounded $42 of gross income is less than the $1,100 threshold that requires tax return filing.

For this reason, no tax return was necessary.

Concluding Thoughts

Although $1.70 is an admittedly small sum, large wealth happens from small savings such as these being given the time to grow. I expect that over the years, contributions like these will grow into larger and larger sums until suddenly, the same people who might mock me for having put $1.70 in my three-year-old’s Roth IRA today will be jealous of the princely sum those small investments have grown into in the future.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine