Roth IRAs are amazing tax saving tools. Roth IRAs allow investors to grow their money tax-free. Even though there is no deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2. The long-term benefits can be significant. We suggest you fund your Roth IRA even when you can’t afford it and that you use taxable savings as your seed money.

On the topic of Roth accounts, I recently received the following reader question:

I really enjoy reading your blog posts. Thanks for all of your insight into investing and planning for retirement. I’d like to ask your opinion about investing for kids. I recently cashed some savings bonds that were issued in the names of my two children (ages 10 and 14). I am thinking about taking the earnings from the sale (and some babysitting money my 14-year-old earned) and opening a Roth IRA for each child. Do you see any downside to this choice? Of course, I will be filing taxes for each child this year.

Funding your Roth IRA is usually one of the best financial decisions you can make, and the younger you get started investing the more time your investments have to compound and generate wealth for you. This makes investing a Roth IRA for your minor children an amazing gift. Alas, there are several limitations.

You are only allowed to fund a Roth IRA up to the IRS limit or the individual’s earned income, whichever is lower.

Your child has to have earned income during the tax year in order to contribute to a Roth IRA. Any earned income qualifies. The income can be babysitting money, full time employment, or even being paid for chores. For this reason, your 14-year-old’s babysitting money would qualify as earned income.

Unearned income does not qualify. This means that the pay-out from a savings bond or other investment income like dividends and interest don’t count as earned income and cannot be used to justify Roth contributions.

The exact dollars that go into a Roth IRA don’t need to be sourced from the earned income. You could contribute your own funds, for example, and let your children keep their earnings. However, your child needs to have proof that they earned as much in earned income as they contributed to a Roth IRA if the IRS audits you.

You can read more about this in my article, “How to Open a Roth for Your Child.”

Source of Earned Income: Household Employer or Self-Employed?

Be careful when you file your child’s income tax return to make sure you understand the most favorable way to treat your children’s income. For domestic tasks, like babysitting, there are often two options — independent contractor or household employee. Wages are taxed differently depending on which option is appropriate. You may have no option; the situation may be a cookie cutter example of only one of these employee types. However, taking the time to educate yourself on the difference may be worth your while.

I have an article that touches on the difference called “Fund Your Child’s Roth with Chore Income” which may help you on that journey. As I say in the article:

If you can be counted as a household employee depends on one question: Does the employer have control over how the work is done (such as when, where, with which tools)? If the employer does, then the individual is an employee. As the IRS says, “The worker is your employee if you can control not only what work is done, but how it is done.” And later, “If only the worker can control how the work is done, the worker isn’t your employee but is self-employed. A self-employed worker usually provides his or her own tools and offers services to the general public in an independent business.”

Although my previous article is focused on parent employers and children household employees, even your neighbor down the street may accidentally be a household employer to your 14-year-old because of the babysitting.

Household Employer rules are found in IRS Publication 926. The employer is addressed as “you” throughout the publication. It is worth noting that the employer is burdened with most of the tax compliance. The Publication states, “You’re responsible for payment of your employee’s share of the taxes as well as your own. You can either withhold your employee’s share from the employee’s wages or pay it from your own funds.” In other words, the household employer is responsible for making sure that, if necessary, Social Security, Medicare, and unemployment taxes are all paid for this employee.

This is why the household employer rules are often begrudgingly referred to as “the nanny tax.” Nannies are frequently paid a large salary to care for the children full-time. Not only does the nanny count as a household employee in the eyes of the IRS, but the large salary makes the wages susceptible to hefty payroll taxes. Parents, ignorant of the IRS rules, often fail to withhold the appropriate taxes. When tax filing comes, they find out their mistake and are required to pay both the employer and the employee’s share out of their own pocket, a large extra expense they might not have been expecting.

For the purpose of your babysitting child, it is important that these rules burden the employers and not the employees. This employer responsibility frees your child of the burden. It means that regardless of how much your child makes babysitting (even if he or she is making four figures or more from one family), if your child is a household employee, it is the parents who are hiring your 14-year-old and not the child who is responsible for meeting the payroll tax requirements.

In contrast, if your child is an independent contractor doing the same task, then he or she is self-employed and would be expected to file Schedule SE to pay these payroll taxes via the self-employment tax (which is 15.3% and only partially deductible).

Again, whether your child can be counted as a household employee depends on one question: Does the employer have control over how the work is done (such as when, where, with which tools)?

Most babysitting gigs, I believe, are easily categorized as household employees. When I was babysitting as a child, I did the work in my employer’s house with my employer’s tools at the time my employer picked and following my employers specific wishes. It seems like an easy argument for most: “I didn’t even have a say on when nap time would be.”

Correctly categorizing an employment situation as household employer instead of self-employed independent contractor can be a 15.3% difference in tax rates.

Filing the Child’s Tax Return

After correctly identifying the type of income you are receiving, you come to the task of filing your child’s tax return.

The IRS does not require dependents whose gross income is less than a certain amount to file a tax return. IRS Publication 501 Table 2 lists the filing requirements for dependents. In 2018, for single, non-blind, minor dependents:

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

Your unearned income was more than $1,050.

Your earned income was more than $12,000.

Your gross income was more than the larger of—

• $1,050, or
• Your earned income (up to $11,650) plus $350.

The $12,000 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.

However, the $1,050 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 $1,050, you must file the child’s tax return and Form 8615 if unearned income exceeds this limit.

In the case of a minor, “unearned income” is likely going to be investment income, such as dividends, interest, or capital gains. “Earned income” would be the babysitting money or other wages.

In your 14-year-old’s case, it sounds like he or she had both unearned income (taxable interest from the savings bond) and earned income (wages from babysitting). If that is the case, they only need to file a return if their gross income was more than the larger of $1,050 or their earned income plus $350.

Although this is a lot of complexity in order to save and invest a hundred dollars or so in Roth IRAs, it is well worth the effort.

Having saved just $100 when you are 14 years old could become $5,065.37 at age 65 from an 8% investment return. Plus, saving those assets in a Roth IRA, rather than a taxable account, protects the assets from capital gains. At 15% of $4,965.37 capital gain, choosing the Roth IRA could be saving $744.81 from your child’s lifetime taxes.

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