Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
There’s always a last-minute rush to open Individual Retirement Accounts in the weeks before the April tax filing deadline. But stop for a minute to think about the benefits of opening an IRA for your young child, as well as yourself.
Many parents are surprised to learn that a minor may indeed open a Roth IRA--subject to some basic earnings requirements. And the tax-free growth inside a Roth IRA could easily create a young millionaire!
The Roth IRA rules apply to everyone, regardless of age. You can invest up to $2,000 a year of earned income in a Roth IRA--if your adjusted gross income is less than $95,000 on a single return or $150,000 on a joint return. The advantage of a Roth IRA is that, although the contribution is not a current tax deduction, all the growth in value comes out completely tax-free after you reach age 59 1/2.
You very rarely think of a young child as “earning” income, except in the case of child models or movie stars. But your child might easily earn enough money to make a Roth IRA contribution--either from a part-time job or even from doing work at home. And that opens up the Roth opportunity.
If you have a teenager, for example, the money that he or she earned in a summer job counts as earned income. Probably, the teenager spent most of those earnings, or is setting some money aside for a near-term goal like a new computer or a car or spending money for college.
What teenager would be willing to lock away $2,000 until he or she reaches age 59 1/2--just to get the tax-free withdrawal of all the investment gains?
Nowhere does it say, however, that the money that goes into the Roth IRA has to come directly from your teenager. It might make sense for mom and dad to put that $2,000 into a Roth IRA for the teenager--up to the limits of the child’s job earnings. Over time, the investment results of that small decision made today turn out to be staggering.
Thus, a $2,000 contribution growing at 10.5 percent annually would swell to $178,786 in 45 years, when today’s 15-year-old turns 60. And, a $2,000 contribution every year for the next 45 years--growing at 10.5 percent per year--would give today’s teen $1,860,458 in 45 years.
(I’ve used historic stock market average gains. But if you think those growth estimates are conservative, here’s what happens with a 20 percent compounded annual rate of return: A one-time $2,000 Roth contribution becomes $7,314,524 in 45 years! Adding $2,000 a year at that rate of return, you’d have nearly $44 million. And that’s the reason it’s so ridiculous to project that the stock market returns of recent years will continue unabated into the future.)
Still, going back to the long-term 10.5 percent average historical return of the stock market, you can see that time is on your side if you start a Roth IRA for your child or grandchild. But the child must have earned income.
For the following portion of the story, I’m indebted to my fellow columnist at www.MoneyCentral.com, tax expert Jeff Schnepper. He routinely advises self-employed parents to hire their kids to work for them. Even young children can file papers, do computer work for a family business or provide some other service for which they can be paid.
For the year 2000, you can pay as much as $4,400 to each child and deduct that amount from your business income, which reduces your own tax. If the children are under age 18, you don’t have to pay any payroll taxes, Social Security or Medicare taxes on the payments to them. And if the parents provide more than half the child’s support, the child can still be claimed as an exemption on the parents’ return.
But what if you’re not self-employed? Here’s where Schnepper, author of How to Pay Zero Taxes, gets really creative. He points out that many Americans hire people to work for them--nannies, gardeners, etc. The money they pay for these services is clearly wages. So Schnepper suggests you hire your children to clean their rooms, wash the dishes or walk the dog--chores for which they previously earned an allowance. But now, you’ll give them a W-2 at the end of the year for $2,000 for services rendered!
Advises Schnepper: “They’ll file a tax return, but because of their $4,400 standard deduction, they’ll pay zero tax. If they’re under age 18, no Social Security or Medicare tax need be paid. And because they’re working for their parents in their home, no child labor laws are violated.”
He added that the “secret is to convert `gifts’ into `compensation’ to qualify for the Roth IRA contribution.”
He pointed out that the Tax Court has validated a parent hiring his 7-year-old son to work for his business and allowed the deduction for reasonable wages paid.
What do you do with that $2,000 of the money you paid the child each year? Invest it in a mutual fund in a Roth IRA. Or open a Roth IRA in the child’s name in a brokerage account and pick a few stocks to teach your child about investing. There’s no better way to teach your child about investing--and the time value of money.
And that’s the Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Devon Energy Corp. Send questions via e-mail at email@example.com. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.