I recently talked to a father who was interested in helping fund an IRA for his young children. I applaud his decision to set his children up for financial freedom in their future. As children, they have at least 50 years for the investment to grow, which should result in a fairly sizeable retirement fund. A $5,000 one-time contribution with 50 years of compounding interest growing at a 10 percent annualized rate could result in a balance of nearly $600,000 by the time a child reaches retirement age.
Since the children are under age 18, the account would be set up as a Custodial IRA, transferring to the child once he or she turns 21. Since this would be a retirement account, withdrawals before age 59 ½ generally come with enhanced tax consequences, unlike a traditional brokerage account; therefore, once 21, the child is more likely to leave the funds alone to grow.
I generally recommend a Roth IRA since the child will not likely receive any current tax benefit from a traditional IRA contribution. With the Roth IRA, the child will be able to enjoy tax-free income in retirement and may even be able to withdraw contributions without penalty should there be a financial need.
To fund the account, the child must have earned income, such as wages, salaries, tips, or other money received as payment for work performed, which could be a part-time job or a gig like mowing lawns in the neighborhood or babysitting. Younger children can be paid to do chores around the house; however, the payment must be considered a “normal” wage for the services provided. It cannot be an allowance.
If you own a sole proprietorship or operate a single-member LLC, you can hire your child as a legitimate employee, His or her wages will be exempt from Social Security, Medicare, and federal unemployment taxes. The key is to be sure to pay an appropriate wage for the work performed.
Furthermore, the IRA contribution does not have to come from the child—the funds can come from the parent. For example, a parent can pay a child to mow the lawn each week. The child could keep the money earned, and the parent could contribute the same amount to the Roth IRA. This brings up another point: The IRA contribution must be the lesser of $6,000 or 100% of wages earned. So, if the child only makes $1,000 a year from mowing lawns, the total IRA contribution is limited to $1,000.
While the child may earn significantly less than $12,400 required to file an income tax return, it is generally a good idea to file a tax return as proof of the earned income to be eligible for the Roth IRA. Furthermore, if the teen has a part-time job where taxes were withheld, he or she may be due a refund. Gig jobs like babysitting or mowing lawns generally do not constitute self-employment, so the child should not owe any self-employment tax.
Rest assured that your child’s Roth IRA won’t affect their financial aid eligibility provided they do not make any withdrawals. Retirement account balances aren’t reported as assets on the Free Application for Federal Student Aid (FAFSA) regardless of who owns the account—the student or the parent.