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"It's no wonder that parents with spare cash dream about starting a Roth for their children. We all worry about the future, and the surest way to make that future secure against whatever the market does is to start investing early while there is plenty of TIME.
"Unfortunately, you can't. Not with a Roth, anyway."
I thought I went on to qualify that and explain the exceptions, but I think a fair number of folks remembered that line alone, so today let me explain a little bit more. If a child has earned income (i.e., money from a job, not dividends, capital gains, interest, etc.), an amount equal to that income (up to $2000) may be invested in a Roth IRA for the child.
A number of popular personal finance advisors suggest putting even young children to work, paying them to take out the garbage, etc., as a way to start a Roth for them. I suppose that is technically possible -- this was another hot point with readers, some of whom thought I said it wasn't legal to do that. What I said was that an allowance doesn't count unless the child is actually working for the money and even then you should consult a tax expert.
I stand by that. I would not want to be the one that suggests a parent can "pay" their kid to make their bed and walk the dog and then deposit that money or an amount equal to it into a Roth IRA and avoid all taxes on the account. Certainly there is no question that a child with a paper route or baby-sitting money qualifies for a Roth IRA, and household chores might qualify, too, but when you get into gray areas, people don't always pay close attention to the details. To me it is irresponsible to suggest something like that, at least not in a column where one can't go into all the details, ramifications, and exceptions. Anyone who wants to walk that close to the line NEEDS to contact a tax expert. Find out if what you are planning qualifies, how much it would be reasonable to pay for the specific job you have in mind, and what kind of documentation you need. Also I'd check the regs every year -- the IRS has been known to redefine things if they think a law is being, shall we say, stretched too thin.
Of course, I don't expect that a parent is going to be sent to the slammer if the account is later determined to be unqualified. Probably the worst that would happen would be that back taxes would have to be paid. But the hassles! Who needs that?
Several readers also wrote to tell me that it is not necessary to file a tax return when the child's income is below the filing limits, just to set up a Roth. That's true, but it would certainly help to establish that the money is earned income. Filing a tax form in a case like this is really very simple. It's not like the kid is going to be deducting home office expenses. Better safe than sorry.
In looking into this I discovered another good reason to file a tax return "just in case." The filing requirements for dependents are often quoted as more than $700 in unearned income (such as investment income) or $4,300 in earned income, like from a job. But there is an additional requirement that I've not seen mentioned, possibly because it's fairly incomprehensible. It says a dependent must file "if your gross income was more than the larger of $700, or your earned income (up to $4,050) plus $250."
Now, I like a puzzle as much as the next guy, so I decided to puzzle that one out. If ever asked this one on a game show, I would want to be on Who Wants to Be a Millionaire rather than Final Jeopardy. It's not a 30-second type of question. But I think I got it, finally. If a kid has both earned and unearned income, he has to file if the unearned income is over $250, unless the two types of income combined are less than $700. ('ll let you know on Thursday how may tax experts write to tell me that's wrong!)
That's another good reason to start a Roth for a kid with earned income. The income from a Roth doesn't have to be reported so it won't trigger that little proviso. Sheesh!
While we are on the subject of my weekend e-mail (Note to self: Don't write about taxes on a Friday. People have more time on their hands!), I was also called to task on the subject of educational expenses. A person wrote to point out that "the educational system" would take all of that money a parent had saved in a child's name to pay for his college education, but only 30% of the parent's savings were expected to be used for his child's college education. Well, duh.
I know this isn't a popular stand (please have mercy, I've read all the arguments!), but it seems to me that the point of saving for your child's education is to pay for your child's education, not to get the taxpayers to do it for you. And yes, I'm the parent of two college-bound teenagers. In fact, this seems to be the one thing about which I get all libertarian. Maybe because the first person who wrote to me about the advisability of keeping college savings accounts in the parent's names so that the kid could qualify for more grants, had previously complained mightily about high taxes and guv'ment interference.
By the way, money in retirement accounts can be used to pay for educational expenses but it is NOT counted when assessing a family or a child's financial resources. Parents may choose to take money from their retirement accounts without the 10% penalty, and those whose accounts have benefited from our recent bull market often do, but they are not required to do so. Retirement account balances don't even have to be listed on financial aid applications. That's reasonable. That money has been set aside for the primary purpose of funding retirement, and there are limits to how much money can be saved in that way. Score another one for the Roth.
Fool on and prosper!
