By Ann Coleman (TMF AnnC)
April 14, 2000

There is more sanity in this world than I thought.

The key piece of IRS information that I was looking for regarding Roth IRAs for kids was supplied by reader Patricia Kerr, a generous-souled CPA. See Publication 926, Household Employees, she said. As it turns out, after Nannygate, Congress took a closer look at the whole domestic employee issue and eventually passed (without much fanfare, it seems to me) a revision of the rules for domestic workers that gets kids, and their employers, off the hook for most tax issues.

This is great news for parents who have wondered about using a child's income as the basis for a Roth IRA. They recognize the power of time as the greatest factor in accumulating wealth.

First, household workers such as baby-sitters, lawn mowers, car washers, etc., are not considered self-employed (as I mistakenly reported on Monday due to the somewhat confusing descriptions given in Publication 4, Student's Guide to Federal Income Tax), but are considered employees of the person in whose home they work.

Now, if little Billy-Joe-Bob buys three lawn mowers and has six other kids working for him all summer, he is clearly self-employed and running his own business and may need to pay not only self-employment tax on his own earnings but withholding taxes on his employees. But that's an exceptional case, and an entrepreneurial kid like that may as well get used to paying taxes -- he'll be making tons of money all his life! Similarly, even a kid under 18 who is offering baby-sitting services in her own home may be considered to be in the child care business and be liable for self-employment taxes if she earns more than $400. Even a kid who supplies his own lawn mower could be technically considered self-employed since providing your own tools is one of the criteria for self-employment. This is where you get into the gray areas that drive us to madness. Check it out if you think this may apply to you or your kid.

Back in the black and white world, it's safe to say that the bulk of most traditional childhood work experiences such as washing cars and walking dogs and picking stones out of the garden (I used to pay the 6- and 8-year-old girls next door $0.25 a bucketful for that chore) are not going to be considered self-employment, although a traditional lemonade stand would -- of course, a lemonade tycoon would still have to net more than $400 before self-employment taxes are triggered.

But for household jobs, kids under 18 at any time during the year can be safely paid any amount and the employer does not have to worry about Social Security taxes unless household employment is the kid's principal occupation. (As long as kid is a student, then being a student is considered his principal occupation, even in the summer.) Just for the record, you don't have to pay Social Security taxes for household employees 18 and over who make less than $1200 (in 1999 the limit was $1100). Note: If you pay even $1 over the exempted amount, Social Security taxes must be paid on the entire amount. But now I'm getting into the tax maze again so let's get back to the issue of how to start a Roth for your kids.

The bottom line is that kids under the age of 18, employed by people other than their parents to work in the employer's own home are exempt from Social Security taxes. If they are performing household services for their parents, they are exempt up to age 21. If they are working for a business that is owned solely by one or both parents, they are also exempt from Social Security up to age 18. (Note: If the business is incorporated, that exemption goes away because the child is then working for a corporation, not directly for the parent.)

So a kid who works for several different household employers could earn up to $4300 without anyone having to pay either income tax or Social Security, or self-employment taxes (the first $4300 in earned income is covered by the child's standard deduction). You should check your state tax laws, though. They vary and don't always follow the federal rules. The important thing is that for every dollar earned, up to $2000, a similar amount (it doesn't have to be the money that was earned -- the kid can keep all or part of that) can be contributed to a Roth IRA owned by the child. Which is the point of all this.

As I've said before, kids in this situation are not required to file an income tax return until they earn more than $4300, but parents (or savvy kids) who are using those earnings as the basis for a Roth IRA may want to file a return anyway, to establish the legitimacy of those contributions.

Maybe I'm paranoid, but the Roth has a "too good to be true" aspect that makes me nervous about the possibility of future attacks on it. It would be a tragedy to start such an account, watch it grow over the years, then be told that there was some doubt about the legitimacy of the original contributions, and therefore the earnings are subject to taxation. That can be avoided by filing a tax return and keeping a back-up record of the income received. That's pretty easy to do. Really. A 50-cent spiral notebook with dates, amounts, and employers listed would do, as would deposit receipts from a bank with a handwritten memo on where the money came from.

Then there is the problem of finding a broker who will open an IRA for a minor child. I've heard from many readers who have had trouble convincing a broker that this is really and truly legal. At this point, of course, if you wanted to set up a Roth with a 1999 contribution, your only choice would probably be a bank or credit union unless you have a brokerage office nearby. The paperwork and check would need to be in the hands of the custodian by Tax Day, which is Monday (not tomorrow!). Reader Jerry Kelley reports that Vanguard was fine with the idea, and his credit union also offered a no-fee Roth IRA for kids. If you aren't particularly concerned about making a contribution for 1999 but are just planning on doing it this year, you will have time to check around for a broker who is really up on tax laws.

You can ask other Fools if they've run into a broker who will start a Roth IRA for kids under 18 on the Discount Brokers discussion board. That's a great place to trade all kinds of information about brokers.

Here's a convenient list of links to the most relevant tax publications on this issue. Happy reading: