If your son or daughter had a summer or after-school job this year, you should seriously consider opening a ROTH IRA.
To be eligible for an IRA, your child must have “income from work,” such as wages reported on a W-2 or “net earnings from self-employment.” The money you give your child for doing chores doesn’t count as earned income, but earnings from babysitting or mowing the lawn may qualify.
You can contribute 100% of your child’s earnings to the account, up to a maximum of $4,000.00 for 2005. If your child earned $2,400.00 for the year, you can contribute $2,400.00 to a ROTH for them. If you earn $4,500.00 you can contribute $4,000.00. You have until April 17, 2006 to open the account and make your contribution for 2005.
If you are self-employed, you can hire your son to work in your business and pay him a salary. A sole proprietor who pays a salary to his or her child under the age of 18 does not have to pay the federal government, and probably the state government, any payroll tax on the wages. Of course, the child must be paid a reasonable salary for doing real work. He can put the wages, up to the maximum of $4,000.00, into a ROTH IRA.
Your child won’t get a current tax deduction for contributions to a ROTH IRA, but most teens don’t need the deduction. A dependent child can earn $5,000.00, including up to $250.00 in interest, dividends, and capital gains, before having to pay any federal income taxes.
Distributions from a ROTH, after age 59½, will be exempt from federal and state income tax, assuming, of course, that Congress doesn’t change the rules in the future. Even if Congress were to revise the ROTH rules in the future, the changes are highly unlikely to be retroactive, so earnings in a ROTH up to the time of the change should remain tax-free.
You can use a ROTH IRA as an incentive to encourage your children to work or save. If your son earns $4,000.00 at a part-time job, put $4,000.00 into a ROTH IRA for him. Or, if your daughter agrees to put $1,000.00 of her salary into a ROTH, give her a 3-for-1 match and put in another $3,000.00.
There is nothing in the tax code that says money put into an IRA for your son or daughter has to come from the child’s own funds.
The $4,000.00 maximum applies for tax years 2005 through 2007. It increases to $5,000.00 for subsequent years. The maximum applies to all IRA accounts. You cannot contribute $4,000.00 to a traditional IRA (deductible) and another $4,000.00 to a ROTH. If you deposit $1,000.00 into a Traditional IRA, you can only deposit $3,000.00 into a ROTH IRA.
If you put the maximum in a ROTH each year for your child starting in 2005, when he/she turns 16, and continuing through 2010, when he/she turns 21, and no other contributions are ever made, the account could grow to $500,000.00 by the time the child turns 65, depending on the interest rate over the years. And it’s all completely tax-free!
There is a potential problem with opening a ROTH account for a child. As with a “Uniform Gift to Minors” custodial account, once the child reaches the “age of majority,” usually 18, they will have full access to all funds in the account and be able to “take the money and run”. . In such a case, the child will pay taxes on the earnings in the account and will have to pay a 10% early withdrawal penalty.