How to Use a Roth IRA for a Minor Child (Megan Russell on Financial Planning for Entrepreneurs Podcast)

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Childhood is a time of acquiring lots of behavior that will be useful for the rest of life. Just as learning to speak would be difficult if the child was never allowed to attempt to make the sounds, so too learning to deal with money is difficult if the child is never given the opportunity to attempt to handle it.

When it comes to teaching financial lessons, setting a good parental example is important, but actually giving the child some first-hand experience making wise financial decisions is essential. This includes both giving the child decision making authority with their own money and giving the child the means to earn money outside of or instead of an allowance.

In 2019, Megan Russell wrote an article called “Fund Your Child’s Roth with Chore Income” where she outlines how even very young children can earn income as household employees from their parents. She also detailed how her own daughter, then age three, was able to fund her Roth individual retirement account (IRA) via this earned income.

Since then, Megan has written several articles detailing the rules behind custodial Roth funding and gained a reputation as an expert in this area.

On Friday, May 14, 2021, Megan Russell was interviewed by Michael Morton of Financial Planning for Entrepreneurs podcast. Michael Morton is the founder of Morton Financial Advice where he provides hourly or subscription-based financial planning and wealth management.

The episode was released Tuesday, May 25. You can listen to the audio here:

 

Why should we bother considering a Roth IRA for a young child?

Roth IRAs are amazing. You don’t get a deduction for contributions, but you do get the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2.

On top of that, at any age and for any reason, you can withdraw what you have contributed with no penalty or tax, and there’s a whole list of additional exceptions that let you withdraw even more tax-free and early.

Funding your Roth IRA is usually one of the best financial decisions you can make, and those benefits are just extended the younger you are when you contribute.

Why don’t more people save money for their child in a Roth?

Some parents don’t realize that a person of any age can own a Roth. A child’s Roth is called a Custodial Roth IRA.

Another reason that people don’t use this as much for children is that your child needs to have earned income to fund their Roth IRA, and a lot of parents don’t realize that household employment counts as earned income for this purpose.

Examples of household employment are Babysitters, Caretakers, Cooks, Housekeepers, Maids, Nannies, Private nurses, Yard workers — those domestic support jobs. Many parents don’t realize that they can hire their children for these household tasks and then fund their child’s Roth IRA.

Does it seem odd to be talking about a retirement account for such a young child?

Saving while you are young is how you get compound growth to work for you. Assuming an 8% annual return and a 60-year time horizon, the future value of funds can be estimated by removing the decimal point. For example, $1 becomes $100 in 60 years and $1,000 becomes $100,000 in 60 years.

In this way, it isn’t hard to imagine making your child a millionaire from diligent very small regular savings. $10,000 saved before age 10 could be $1M by age 70.

That being said, I personally don’t think about my daughter’s custodial Roth IRA as primarily retirement savings. I’d love for her financial career to be smooth enough that these funds aren’t needed until then, but that’s not always the case. I see the funds I’ve saved for her more as being a way to help her get started. There are many trials in life, and only some of those can be solved with money. So, I see these funds as the start to help her solve the problems money can solve later.

Where do you actually open the account?

Most major custodians offer a Custodial Roth IRA. I have my daughter’s at Charles Schwab. Fidelity also offers them.

When you are setting it up, it is important to understand the language so you fill out the forms right:

The child is the account holder.

The adult on the account is called the custodian.

Until the age of termination, the custodian is the only one who will be permitted to make decisions on the account even though the assets are owned by the minor.

The custodian is held to the fiduciary standard, meaning they are legally required to act in the minor’s best interests.

At account set-up, you get to pick the age of termination up to your state’s maximum. You can look up your state’s age of majority rules here . I recommend picking the maximum because you can always decide to let the child have the assets outright earlier but you can’t take the funds after the age of termination has been reached.

What jobs can you give to your child?

What is your child capable of doing?

It’s almost easier to think of what you can’t hire your child to do. For example, you can’t pay your child to get themselves dressed in the morning. That’s a legit chore that you could pay a nanny to do, but it’s your child’s responsibility to start with so getting your child to do it is not outsourcing. It’s just holding them accountable for what they already need to do.

Similarly, if you’re going to punish your child for not doing the task or they have no choice and have to do the task no matter whether you are paying them or not, then that’s not employment. The chores that fall into this category vary by household culture but still make a difference on the legality.

My daughter is employed “at-will,” meaning we have no employment contract. Either of us can terminate the employment arrangement whenever we want. That means that if she says she doesn’t want to do the job, then she doesn’t have to do the job. Just like a cleaning lady who calls in sick, tough luck. She’s not doing it.

If that arrangement makes sense for the chores you are thinking about, then those tasks are great candidates for outsourcing to your children.

We hire my daughter to do things we legitimately don’t want to do. I dislike sorting laundry. I find myself living out of my laundry hamper at times rather than put it all away. My daughter is fully capable of independently sorting laundry. It’s my responsibility to sort my laundry but I hire her to do it whenever I can.

What do you need to track?

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.

This list is made from the guidelines in IRS Publication 926 Household Employer’s Tax Guide and the guidance that can be lifted from tax court case decisions.

I don’t think it’s too strong to say that: If you want to hire your child, you need to have this record.

If you don’t want to reinvent the wheel, I made one for my own household use which you can use to keep this record. Here it is as a Word Document (in case you want to customize it) and here it is as a PDF.

Do you need to file anything special on your tax return?

I have a lot of articles on this topic, so for those listening who want the details, they should go read some of them. You could start with “Do Children Need To File A Tax Return To Fund Their Roth IRA?

For the average family, there is no special IRS reporting and no tax return required for the child. The simplest summary is if your child has more than $1,100 in total income for the year, you should read the filing rules to check whether they need to file.

While we’re on the subject of IRAs, should we consider a Traditional IRA?

If your children are the Olsen twins and they are a millionaire in the highest tax bracket, a traditional IRA might be wise. However, most children are effectively in the 0% tax bracket as their earned income is lower than the standard deduction, so a traditional IRA would actually be punitive. They’d put it in without any benefit and then have withdrawals taxed at income rates.

Is there a limit to how much you can put into the Roth IRA?

The annual contribution limit is the smaller of either $6,000 or your taxable compensation. So for most children, how much they earn is their limit. The first year my daughter worked for us, she earned $1.70, so $1.70 was her contribution limit.

Are there different considerations depending on the age of the child?  Or, even as the account balance grows and the child gets older?

If your child is not a child any more, as in they are age 18, 21, or older, some of the parental exceptions go away. For examples, wages paid to these adult children are subject to payroll taxes again. That’s Social Security and Medicare. Depending on where you live, you may also have some state payroll taxes that get added in.

Other than that, there’s not really any other special considerations. Minimum wage laws do not apply to parents employing their own minor children, and people of every age benefit from a Roth.

Unlike an UGMA (which is a custodial brokerage account), the Roth IRA is tax-free, so its gains, interest, and dividends won’t affect your child’s future tax planning.

Unlike a 529 plan, retirement accounts, owned by you or your child, are not counted in determining the Expected Family Contribution for purposes of federal financial aid. So the Roth IRA is compatible with future FAFSA filing.

What about investments inside the IRA?  What do you recommend?

First off, although I love exchange-traded funds (ETFs), if you’re investing small sums you should focus your research on mutual funds. Most custodians do not yet allow fractional trading of ETFs, but you can with mutual funds. So with a mutual fund, you’ll be able to keep small sums fully invested rather than sitting around waiting for $50 or more to buy an ETF.

Second, although many custodians like Charles Schwab have moved to transaction-free online trading for all ETFs, mutual fund purchases still often carry a large transaction fee. To avoid having that fee take your entire investment, you need to shop the custodian-specific list of no-transaction-fee mutual funds.

Third, very volatile investments with a high expected return are great investments for investors with a long time horizon and no withdrawal needs, which describes most children. So great funds for children would be emerging markets, small cap value, mid cap value, or large cap.

Fourth, you’ll want to focus on picking a fund with a low expense ratio. My advice is to focus on funds where the expense ratio begins point zero, such as zero point zero four percent. A lower expense ratio means more of the return is kept in the account for your child.

What else have we not considered?

Although hiring your children can be smart tax planning, it is not a step that should be taken lightly. Time is the most valuable commodity any of us have, and time as a child is even more precious and rare. If your child doesn’t want to work or you don’t want to hire them, that’s fine. If they only earn pocket change, that’s also fine.

This past tax year, my daughter earned $12.51 as a household employee. To estimate it’s future value, we take the decimal out. That’s $1,251 dollars at age 64. The people who might mock putting pocket change into a custodial Roth IRA today will be jealous of the princely sum those small investments have grown to in the future.

What about for business owners?

Specifically for that crowd, you do have the option of employing your children in the family business. At any age a child can be employed by a business owned entirely by their parents as long as it is not hazardous.

Employing them in the business can get you a business deduction, if they meet the requirements your child can participate in the company 401(k), and they can contribute to a Roth IRA. So a child earning $500 in the family business can defer $500 to the 401(k), receive the 401(k) employer match and profit sharing, and then also contribute $500 to their Roth IRA.

The IRS is more likely to challenge children employed by their parent’s small businesses, because of that business deduction. Therefore, make sure all your records are super clear, document everything, do everything the cleanest way possible, treat them just like other employees, and if they are really young maybe even film them or photograph them doing the task so you have evidence of their capability.

When I was a child, I remember my dad telling me about the youngest child to win against an IRS challenge. She was a preschooler who knew her alphabet and was being paid as a clerk to file documents in her mother’s business filing cabinet. The IRS challenged the business deduction for those wages but the mother’s studious records of the girl’s employment and record of the child’s capability prevailed.

On the other end, there was a mother who employed her three children to do some filing work in her business. Her so-called records were receipts for household expenses like buying pizza for her children. She was saying she paid them in those purchases. She lost that one, partially because she never actually paid the children directly but also because she didn’t have record of how long and when her children worked.

Everyone employing their children should keep records, but if you are employing them in a business which will deduct those wages, keep records even more so.

I often say that if I’ve done something wrong it will be my own documentation that will be used to prove it. Record and save everything.

Photo by Isabella and Zsa Fischer on Unsplash

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Chief Operating Officer, APMA®

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. She is the author of over 700 financial articles. Her most popular post is "The Complete Guide to Your Washing Machine" while one of her favorites is "Funding a 3-Year-Old’s Roth IRA."