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Besides being berated for suggesting caution when it comes to setting up what amounts to a lifetime tax shelter for your children, I was warned that it would limit educational grants, kill the work ethic, and cause dental cavities.
Oh, well, everyone has an opinion...
Most of my readers seem to think that setting up a Roth IRA for their children when it is possible to do so is a pretty good idea, so today, as the deadline approaches, I thought I would review what I have learned about the subject. And thanks to those of you who shared bits and pieces of information with me.
First, a Roth IRA can only be funded with earned income, earned by the child, that is, so unless your children are old enough to actually perform a valuable service, they won't qualify for a Roth. Income from dividends, interest, or capital gains doesn't qualify as earned income. However, if you pay your children for household chores, that money would qualify, so a 7-year-old who sets the table every night and takes out the trash twice a week could be paid (at no more than market rates) for those services, and that money would constitute earned income.
Having said that, let me make it very clear that simply paying your children an allowance would not qualify as earned income. The money has to be specifically in payment for household chores or work performed for a parent's business, and there are further qualifications when it comes to paying your children for working in a parent's business. Read up on the details.
But the good news is that you don't need to contribute the actual cash that the child earns to the IRA. If a child earns $1200 a year, she can keep it all while you, the parent, deposit $1200 into the Roth. In effect, this doubles what you can pay your children for household chores, and it's perfectly legal. Of course, you might want to modify that as a way to teach your children about the value of saving by expecting the child to contribute something as well, or by an arrangement that matches anything the child puts into a short-term savings account with a contribution to her Roth. There are endless variations on this theme, but the key is that parents can, if they wish, give their children a gift equal to the amount that they have earned, and that gift can go into a Roth to fund their education, first house, or retirement.
The fly in the ointment is that children who work outside the home -- as the neighborhood dog walker, baby-sitter, lawn mower, plant waterer, etc. -- are considered "self-employed." While their income definitely qualifies for establishing the amount that can be contributed to a Roth, such work is subject to self-employment tax. (See Publication 4: Students Guide to Federal Income Tax.) There are two exceptions: Newspaper delivery persons under the age of 18 (I guess they had a good lobby!) are not subject to self-employment tax, and children who work for their parents are not subject to Social Security up to the age of 18 if the work is for the parent's business or up to age 21 for household work. That is the provision that makes this plan work.
A note on self-employment tax. It kicks in at $400. (See Publication 533: Self-employment Tax.) The baby-sitters of the world need a better lobby. But the fact is that if a kid earns over $400 performing services for people other than his parents, he is considered self-employed and needs to pay self-employment tax, which is just like Social Security, except that instead of the employer kicking in half of the amount due, the self-employed person gets to pay it all -- and it's a stiff tax, 15.3%. (Actually it's 15.3% on 92.35% of total net income -- there's a reason for that, but you don't want to know the details.)
As a further way to discourage self-employment, things like personal exemptions and standard deductions are not part of the calculation, so self-employed persons with the gumption to start their own businesses are paying 15.3% tax on even very small amounts. Not that I think that's unfair or anything...
While all this is something of a bummer and can be a paperwork nightmare, the silver lining is that it is definitely possible to use even small amounts of income that children earn as the basis for setting up a Roth IRA for them, and at least as long as they are working for their parents either in the home or in a business, they aren't subject to self-employment or Social Security taxes.
Now, I took considerable flack for suggesting that parents file an income tax form for their kids if they intend to set up a Roth based on income from household chores, but I don't like to live dangerously where the IRS is concerned. True, it is not necessary to file if the child has income of less than $4,300 (more stringent requirements prevail if the child has unearned income, so check the regs) or less than $400 if the income is from self-employment outside the home, but it can't hurt. Providing documentation in the form of a W-2 and 1040 that work was actually performed could save you considerable hassle in the future.
One week from today (April 17) is the last day that you can make a contribution to a Roth IRA for 1999. If you want to maximize your contributions, get that Roth set up this week so you can make last year's deposit now and still be able to deposit up to $2000 this year.
And if you haven't set up your own Roth, get cracking! Here's a good place to start: Our new Discount Brokerage Center with side-by-side comparisons for five popular discount brokers and a discussion board so that you can compare notes with Fools who have actually used many of them.
Fool on and prosper!