If you son or daughter had a summer or after-school job this year you should seriously consider opening up a ROTH IRA account.
To be eligible for an IRA your child must have “earned income”, such as wages that are reported on a W-2 or “net earnings from self-employment”. Money you give your child for doing chores around the house won’t count as earned income, but earnings from babysitting or mowing lawns may qualify.
You can contribute 100% of your child’s earnings to the account, up to a maximum of $4,000.00 for 2005. If your son earned $2,400.00 for the year you can contribute $2,400.00 to a ROTH for him. If he earns $4,500.00 you can contribute $4,000.00. You have until April 17, 2006 to open the account and make your contribution for 2005.
If you are self employed you can hire your child to work in your business and pay him, or her, a salary. A sole-proprietor who pays a salary to his or her child who is under age 18 does not have to pay the federal, and probably state, government any payroll tax on the wages. Of course the child must be paid a reasonable salary for doing actual work. You can put the wages, up to the $4,000.00 maximum, into a ROTH IRA.
Your child will not get a current tax deduction for contributions to a ROTH IRA, but then most teen-agers don’t need the deduction. A dependent child can earn $5,000.00, including up to $250.00 in interest, dividends and capital gains, before having to pay any federal income tax.
Distributions from a ROTH, after age 59 1/2, will be exempt from federal and state income tax, assuming, of course, Congress does not change the rules in the future. Even if Congress was to revise the ROTH rules down the road it is very unlikely that any changes would be retroactive, so earnings on a ROTH up to the point of change should remain tax-free.
You can use a ROTH IRA as an incentive to encourage your children to work or to save. If your son earns $4,000.00 in a part-time job put $4,000.00 into a ROTH IRA for him. Or, if your daughter agrees to put $1,000.00 of her salary in a ROTH give her a 3-for-1 match and put in another $3,000.00.
There is nothing in the tax code that says that the money deposited in an IRA for your son or daughter has to come from the child’s funds.
The $4,000.00 maximum applies for tax years 2005 through 2007. It increases to $5,000.00 for years thereafter. The maximum applies to all IRA accounts. You cannot contribute $4,000.00 to a traditional (deductible) IRA and another $4,000.00 to a ROTH. If you put $1,000.00 in a traditional IRA you can only put $3,000.00 in a ROTH IRA.
If you put the maximum into a ROTH each year for your child beginning in 2005, when he/she is age 16, and continuing through 2010, when he/she will turn 21, and no other contributions are ever made, the account could grow to as much as $500,000.00 by the time the child reaches age 65, depending on the interest rate over the years. And it is all completely tax-free!
There is one potential problem with opening a ROTH account for a child. As with a “Uniform Gift to Minors” custodial account, once the child reaches the “age of majority”, usually age 18, he/she will have full access to all the funds in the account and can “take the money and run”. In such a case the child will be taxed on the earnings in the account and will have to pay a 10% premature withdrawal penalty.