Roth IRAs for Children

The following is a guest post from Harvey J. Poorbaugh, Editor of Fidelity Select Fundranker.

There is plenty of controversy over the relative merits of traditional IRAs and Roth IRAs for worker-age individuals who qualify for both.  In general, you get to deduct contributions to a traditional IRA up front, but you pay taxes when you withdraw money from it after age 59½ on both your contributions and whatever gains accrue; you don’t get to deduct contributions to a Roth IRA up front, but you don’t have to pay taxes after age 59½ when you withdraw money from it on your contributions or any gains that accrue.  Many variables make the decision very difficult to quantify, and some of the questions that arise can’t be answered without a crystal ball, such as what tax rates may be like in the future when you withdraw money from your IRA.

But what about that babysitting money or lawn mowing money your child makes while they are in middle school or high school?  What about that first part-time job they get at the corner drugstore?  It’s pretty likely that with their income level, they won’t even have to file an income tax return, and yet this income is considered after-tax income.  You couldn’t ask for a better situation for a Roth IRA to make sense.  Your child won’t pay income taxes on the income, but she can take full advantage of a Roth IRA.  Plus, that money will be in your child’s Roth IRA for a long, long time; time during which it can grow and grow and grow.

Your child’s Roth IRA contribution for 2008 (contribute by April 15, 2009) is limited to her earned income or $5,000, whichever is less.  With the jobs we’re talking about, she is likely to earn less than $5,000.  So do you ask her to give up her hard-earned money, which, since she made the effort to earn it, she must want for something else?  Well, that depends on your situation.  If you think getting your child set up with a life-long investment is important, and you have the means, you can spring for all or most of the money to put in it (you can give up to $12,000 per year to an individual without the gift being taxable).  After all, it probably won’t be a large amount the first few years.

You are probably asking, what if my kid only makes $50 babysitting the first year she makes any money?  Check with your bank or credit union to see what their minimum requirements are for opening a Roth IRA.  Many have very low minimums, so you can start very small.  Again, you can still open a Roth IRA for your child and make a 2008 contribution through April 15, 2009.

One of the advantages of a Roth IRA over a traditional IRA is that your child can make certain withdrawals from her Roth IRA before age 59½ without including the amounts as taxable income or having to pay a penalty:  for example, she can withdraw any or all of the contributions she makes over the years, or she can withdraw up to $10,000 for qualified first-time homebuyer expenses, even if they exceed all of her contributions.  Investment earnings that accrue in a Roth IRA are another story; if your child withdraws earnings (other than as qualified first-time homebuyer expenses) from her Roth IRA before age 59½, she will have to include those amounts as taxable income and will have to pay a 10% penalty, as well.

This is a great opportunity to teach your child the importance of saving for the future.  Show her how her Roth IRA may grow over the years from her contributions as well as investment returns.  Review various ways her Roth IRA can be invested and decide together which to use.  If you want your child to feel more ownership of her Roth IRA, you and your child could agree on a “company matching” strategy, where you play the part of the company and do the matching (probably way more generously than your company matches your 401K), and your child puts in some part of her earnings.

Comments

[It's Frugal Being Green]

They definitely are great. My parents helped me get a Roth IRA started when I was 16 and had my first job.

[Baker @ ManVsDebt]

Wow, not only had I not thought about this... I actually hadn't heard about it either. This is a fantastic idea for people with teenage kids!

[bigbartha]

Warning: My Dad opened a Roth IRA for me at TD Ameritrade (then TD Waterhouse) with $150 that I earned selling soda. He put the money in a money market (I guess because of the fees/minimums needed to invest it). Two years ago it was worth $163 and I rolled it over to Vanguard. But only about $85 rolled over. TD Ameritrade took $75 of my money to execute the transaction. Talk about a bad return on investment!

[Sarah]

This sounds like a good idea but the kid had better keep close track of that 'earned income' in case the IRS challenges it, since she probably won't get a W-2 or file a tax return.

Also, I would check to see if contributions held in a Roth IRA are considered student assets for the purposes of college financial aid. (Earnings aren't accessible without penalty, so they probably aren't, but contributions? Who knows?)

[Eric]

@bigbatha

I had a TD Ameritrade account and I explicitly saw a fee listed for rolling over to another brokerage firm.

You should have withdrew the money in cash and deposited yourself (which was what I did). I know you probably didn't know about it but it would be easy to ask before doing it.

[Harvey J. Poorbaugh]

You make some good points. It definitely is a good idea to keep track of earned income contributed to a Roth IRA, especially if there is no W-2 form associated with it. It's unlikely the IRS would challenge a small Roth IRA, but you can't be too careful with the IRS.

The Free Application for Federal Student Aid (FAFSA) that students fill out for financial aid consideration doesn't ask for information about IRA assets, so they are not included when the Expected Family Contribution is calculated. That actually makes a Roth IRA a great way to save in your child's name without affecting financial aid. Keep in mind, though, that your child will fill out a FAFSA for each year that they are in college. Any withdrawals from a student's Roth IRA that get included in taxable income (usually those that exceed total contributions) will go onto the next year's FAFSA as taxable income for the student.