Summary: This article is part of our Legacy series, which focuses on financial planning for your children. This week, we explain why it is a good idea to set up a Roth IRA retirement account for your kids. Starting your children’s Roth gives them a head start to building financial security. It also teaches them about financial responsibility. We also discuss how Roth IRAs work when you own your own business like we do.
It may seem a little too early to be thinking about your children’s retirement. But even if your child is still young, it might not be!
Roth IRAs are retirement accounts that can be opened for children as long as they have earned income. Roths are tax-free in and tax-free out, and they offer the flexibility of tapping into account contributions tax-free if needed even before your child reaches retirement age.
Plus, you can imagine what compounding looks like if you start an account when your child is a teenager or maybe even younger!
In this post, we cover why you should consider setting up a Roth IRA for your children, how to do it, and what to do if your children work for you, like ours will in our real estate business in the near future.
Should You Set Up a Roth IRA For Your Kids?
There is no age limit for opening a Roth IRA, so it’s ideal for kids. Of course, you as the parent will have to open it for them as a custodial Roth. But that can be easily done with minimum fees at several brokerage firms.
The only stipulation to having a Roth IRA is that your child has to have made earned income in the past year. This income can come from a part-time W-2 job (if your child is a teenager) to self-employed pet sitting or lawn care or even modeling or document filing (if you child is a little younger, like ours).
The age cut-off for when a child can earn money from you, as a family member, or at an outside job varies from state to state. When I researched the state of Washington’s rules, I found that you have to get court clearance for your child to work if they are under 14 years old.
Remember, the jobs that your children do to earn money for their Roths have to be age appropriate. It’s not believable if you pay your three-year old child to do bookkeeping for your real estate business, for example. But paying your ten-year-old to help with filing and scanning… that’s much more reasonable.
The Details
The best thing about the Roth IRA is that it is tax- and penalty-free. What this means is that any money you contribute into the account for your children (up to a certain limit) goes in tax-free and comes out tax-free as long as your children keep it in the account until they reach age 59 ½. If your children harvest some of the money earlier than retirement age (to buy that cashflowing duplex that they found!), they still do not need to pay taxes on the contributions, but they will need to on the accrued earnings.
Keep in mind that the contribution limit for a tax-free Roth IRA is $6,000 a year or the total earned income for that year, whichever is less. For example, if your child made $1,000 walking the neighbor’s dog that year, then the limit is $1,000. If your hard-working teenager made $8,000 at her part-time waitressing job, then the limit is $6,000.
How Do You Open a Roth IRA?
If your child is under the age of eighteen (or nineteen or twenty-one depending on the state), you’ll need to open the account as a custodial or guardian account. Though the account will be in your child’s name, you will control the assets until your child is of age.
Not all firms allow minors to have IRAs. Some that do include Charles Schwab (our personal favorite) and Fidelity.
What If Your Children Work For You?
If you have an umbrella LLC like we have, you can hire your under-eighteen children to work for you, which is a great way to teach them about your business while providing a way for them to earn money. Their wages will be exempt from Social Security, Medicare, and federal unemployment taxes. You are also eligible to receive a tax-break for employee wage expenses, so it’s a win-win.
So what does this look like in practice?
Let’s say we want to pay our three-year-old as a model for our blog (which is the only age-appropriate work she can do on our business at this point).
First, we’ll have to research appropriate pay for three-year-olds to make per hour for modeling. Then we’ll have to figure out how much she will have made over the course of the year according to the work she’s done.
Then, we’ll have to get a lawyer’s advice to reach out to the state and get approval for her to work for us.
Next, we’ll have to pay her through our business. As mentioned, this will be a business expense, which will be tax deductible for us. And, since our daughter will not be making enough to be taxed by federal or state income tax standards, her pay will come to her tax-free.
Finally, I will deposit her earnings into her custodial Roth IRA to begin compounding.
This sounds like a lot of work for very little benefit. After all, it will probably only save us a couple hundred a year in taxes for a lot of effort. But let’s look at this from a different way.
Let’s assume that our daughter earns just $500 dollars a year starting this year. At 7% growth, that means she’ll end up with $497,000 by age 65! Not bad at all!
Ready to Start?
If you have children and own your own business like us, you are in a prime situation to be able to jump-start your child’s retirement savings through a Roth IRA.
Also, if you don’t own your own business, but your children work at a summer job or after school (or even have a lemonade stand!), you should consider encouraging your children to put some of their earnings into savings in a Roth.
Have you started a Roth IRA for your child? Tell us about it!
