IRAs for Kids

Working at a tender age is an American tradition.

What isn’t so traditional is the notion of kids contributing to their own IRA, especially a Roth IRA.

But it should be a tradition, because it’s a really good idea.

Here’s what you need to know about IRAs for kids. Let’s start with the Roth IRA option.

Roth IRA Contribution Basics

The only federal-income-tax-law requirement for a child to make an annual Roth IRA contribution is to have enough earned income during the year to cover the contribution. Age is completely irrelevant.

So if a child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year.

For both the 2021 and 2022 tax years, your working child can contribute the lesser of

his or her earned income for the year, or $6,000.

While the same $6,000 contribution limit applies equally to Roth IRAs and traditional IRAs, the Roth option is usually better for kids for the reasons explained later in this article.

Key point. A contribution for your child’s 2021 tax year can be made as late as April 15, 2022. So, there’s still time for that.

Income Restriction

There’s an income restriction on the right to make annual Roth IRA contributions.

For 2021 tax year contributions, the Roth contribution privilege for an unmarried taxpayer, such as your hardworking child, is phased out between modified adjusted gross income (MAGI) of $125,000 and $140,000.

For the 2022 tax year, the phase-out range is between MAGI of $129,000 and $144,000.

The income restriction won’t be an issue for your kid, unless he or she is the HEKOAT (highest-earning kid of all time), but we want you to be fully informed.

If your child’s earnings are from a regular self-employment activity—such as lots of yard work, babysitting, or pool cleanings—the child must include Schedule C with his or her Form 1040 and must fill out Schedule SE to compute the resulting self-employment tax bill, which will equal 15.3 percent of net self-employment income.

Question. Is your child’s activity regular and substantial enough to qualify as self-employment income that’s exposed to the self-employment tax?

Fortunately, your child can use his or her standard deduction to shelter up to $12,550 of 2021 earned income from federal income tax (but not self-employment tax), or up to $12,950 of 2022 earned income from federal income tax.

Modest Contributions to Child’s Roth IRA Can Amount to Big Bucks by Retirement Age

By making Roth contributions for a few years during teenagerhood, your kid can potentially accumulate quite a bit of money by retirement age.

But realistically, most kids won’t be willing to contribute the $6,000 annual maximum even when they have enough earnings to do so.

Try talking a teenager into saving a significant amount of money instead of spending it all. Good luck! Be satisfied if you can convince your child to contribute at least a meaningful amount each year. Here’s what could happen.

• Say a 15-year-old contributes $1,000 to a Roth IRA at the end of each year for four years. Assuming a 5 percent annual rate of return, the Roth account would be worth about $33,000 in 45 years, when the child is 60 years old. If you assume a more optimistic 8 percent return, the account would be worth about $104,000 in 45 years.
• Say the child contributes $1,500 at the end of each of the four years. Now the Roth account would be worth about $49,000 in 45 years, assuming a 5 percent rate of return. With an 8 percent return, it would be worth about $155,000.
• Say the child contributes $2,500 at the end of each of the four years. Assuming a 5 percent return, the Roth account would be worth about $82,000 in 45 years. Assuming an 8 percent return, the account value jumps to a whopping $259,000. Wow!

You get the idea. With relatively modest annual contributions for just a few years, Roth IRAs can be worth eye popping amounts by the time your “kid” approaches retirement age.

What About Contributing to a Traditional IRA?

For a kid, contributing to a Roth IRA is usually a much better idea than contributing to a traditional deductible IRA.

That’s because your child can withdraw all or part of any annual Roth contributions—without any federal income tax or penalty—to pay for college or for any other reason. Remember, that refers to contributions, not earnings. You or your child generally cannot withdraw Roth earnings tax-free before age 59 1/2.

In contrast, if your child makes deductible contributions to a traditional IRA, your child must include all subsequent withdrawals in gross income. Even worse, your child’s withdrawals from a traditional IRA before age 59 1/2 suffer a 10 percent penalty tax unless an exception applies (one exception is to pay for qualified higher-education expenses).

Advice. Even though your kid can withdraw Roth contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the Roth account balance as possible untouched until retirement age and even later to accumulate a large tax-free chunk of money.

“What about tax deductions for traditional IRA contributions?” you ask. “Isn’t that an advantage compared to Roth IRAs?” Good question.

As you know, there are no write-offs for Roth contributions, but a child probably won’t get any meaningful write-offs from contributing to a traditional IRA either. That’s because an unmarried dependent child’s standard deduction will automatically shelter up to $12,550 of 2021 earned income from federal income tax and up to $12,950 of 2022 earned income. We assume any additional income will be taxed at very low rates.

So, unless your child has enough taxable income to owe a significant amount of tax (not likely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that’s the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top.

Employing Your Child in Your Business Is a Really Great Idea

Hiring an under-age-18 child as a part-time employee of your sole proprietorship business or husband-wife partnership business is a great tax-saving strategy for several reasons.

First, in your proprietorship, your under-age-18 child’s wages are exempt from Social Security, Medicare, and FUTA taxes. This break applies equally to single-member LLCs treated as sole proprietorships for federal tax purposes and to husband-wife LLCs treated as husband-wife partnerships for federal tax purposes.

Second, you can deduct the child’s wages as a business expense, which lowers both your income tax and self employment tax bills.

Third, the kid’s standard deduction ($12,950 for 2022) provides shelter from the federal income tax.

Fourth, your child can use the wages paid by your business to fund annual Roth IRA contributions.

What if you operate your business as an S or a C corporation? In that case, your child’s wages are subject to Social Security, Medicare, and FUTA taxes as is the case for any employee.

But multiple tax breaks are still available.

Your corporation can deduct the child’s wages (and the employer’s share of payroll taxes on those wages) as a business expense on the corporation’s tax return. The child’s wages can be completely or partially sheltered from federal income tax with the standard deduction ($12,950 for 2022). And the child can use the wages to fund annual Roth contributions.

Takeaways

For those young workers who have W-2 income, it’s time to consider making annual contributions to a Roth IRA.

For most children, this is a much better investment option than the traditional IRA.

The child can later remove the contributions (not the earnings, just the contributions) from any Roth IRA and use that money for college or any other purpose.

And if the child can wait until retirement age to tap the money, this nest egg can grow into a tidy sum—and all of it is tax-free once the child is age 59 1/2.

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