Roth IRAs are traditionally thought of as a savvy investment tool for individuals looking to keep more of their money long-term in retirement. It can, however, be an equally smart tool for children (or their parents) looking to jumpstart a long-term savings plan. Roth IRAs are ideal for children since the investment has more time to grow and earn compound interest and the use of the funds is more flexible than traditional IRA savings plans.
Roth IRAs are a type of retirement account where the funds initially invested are not tax deductible—meaning that the account holder still pays income tax on the funds being contributed to the account (unlike traditional IRAs which are tax deductible up to the contribution amount). The benefits kick in on the back end since all funds withdrawn from the account in retirement are not considered taxable income, including any growth on the initial investment. Roth IRAs are geared toward individuals who expect their tax bracket to be higher in retirement than their current tax rate. This mostly applies to lower income young workers who can afford to stash money away now without necessarily needing an immediate tax benefit. Younger workers usually also qualify to meet the income restrictions for Roth IRAs since they almost always fall below the modified adjusted gross income cap of less than $122,000 per year for Roth IRA eligibility.
Based on their generally low income and low need for disposable income, children are ideal candidates for a Roth IRA. There is no age requirement to set up an account for a child, but for children under 18, the account remains under the parent or guardian’s name until the child turns 18. There are, however, income requirements. In order to establish a Roth IRA for a child, the child must have earned income, as defined by the Internal Revenue Code (IRC). Children who do not have earned income are ineligible to contribute toward a Roth IRA. Earned income must include either income from a job where the child receives a W-2 or Form 1099, or from the child’s own entrepreneurial endeavors. This could be a retail job, lifeguarding, babysitting, dog walking, or any number of other age appropriate activities for which the child earns money. It does not include an allowance or investment income.
For younger children, parents may be able to pay them a “salary” for work done around the house if the work is legitimate and the “salary” matches the going market rate. In other words, the pay must be reasonable for the work done with the child receiving W2s and the parents making any applicable employment tax payments. Paying your child $200 for an hour of babysitting a younger sibling is not reasonable and will not pass muster from the IRS. Likewise, an allowance for not doing any work does not count as earning an income. Children can work for a family business, but parents should be sure to pay the child what they would pay anyone else working there based on similar age, experience, and maturity and file all applicable returns. For children not engaged in a typical employer-employee relationship, it is important for parents to keep track of the type of work the child performed, when the work was done, who they worked for, and how much the child was paid. This is in case the IRS needs verification of the child’s income for tax purposes. If contributing to a Roth IRA, the child may need to have a tax return filed to report their income.
Regardless of where the child’s earnings come from, their contributions to a Roth IRA for the year are limited to the extent of their earnings. For instance, if a child earns $1,000 in a year for walking the neighbors’ dogs, the child can only contribute $1,000 to a Roth IRA for that year. Parents are able to “match” the child’s income, however. Alternatively, if the parent chooses to let the child keep the money and contribute the $1,000 from their own funds, they can do so and claim an equivalent tax deduction under the gift tax exclusion. But wherever the funds come from for the contribution, they cannot exceed the $1,000 that the child earned for that year. This means that any combination of child/parent/family contributions cannot exceed the child’s earned income for the year. Further, at all times, the child’s eligibility for contributions are capped at $6,000 annually. Regardless of how much income a child has earned for a given year, he or she cannot contribute more than $6,000 per year.
Roth IRAs also benefit children because they are more flexible than traditional IRAs in that the assets can be used for more than just retirement once they reach age 60. Funds can be withdrawn early for a first time home purchase, qualified education expenses, or for emergencies. For first time home purchases, the funds must be used as a down payment or closing costs. Withdrawals are capped at $10,000, but they are penalty and tax free. For education withdrawals, the child will face a tax liability for the interest and earnings accumulated since the initial investment, but the general 10 percent early withdrawal penalty does not apply if the funds are used for qualified education expenses. These expenses are defined by the IRC and include items such as tuition, fees, books, supplies, equipment, and most room and board charges. Emergency withdrawals are subject to both taxes on the earnings plus the general 10 percent early withdrawal penalty.
Roth IRAs are an ideal investment tool for children looking to start saving for their long-term future. They are also a valuable way for parents to teach their children about savings and investment for when the child is old enough to buy their own home or even retire. They serve as a great way to jumpstart a savings process.
With contribution from Sarah Rothermel, J.D. Widener Law Commonwealth.