By H. Quincy Long
“How can my minor child have a Roth IRA?” If I only had a million dollars for every time I have been asked this question, I would be a very rich person! When entrepreneurial people learn of the myriad of possibilities for non-traditional investments within a self-directed IRA, they usually immediately see the benefit of starting on their child’s retirement now in addition to utilizing their own IRAs. In this article I will discuss the benefits of starting an IRA early, how a minor can qualify for a Roth IRA, the tax filing requirements for a minor with earned income, and what can be done with the IRA once the money is deposited in the account.
First, let me briefly discuss the benefits of starting early on retirement savings. Assume your 15 year old daughter starts off her Roth IRA with $1,000 from her earnings and adds $1,000 per year until she retires at age 67. If she can earn an average return of just 10% per year, her tax free Roth IRA will be worth $1,552,472 at retirement – not bad for only investing a total of $52,000 over 52 years. Contrast this with an individual who starts saving at age 35 and puts $5,000 in for 32 years with the same annual return of 10%. His Roth IRA will be worth approximately $1,111,253 when he retires at age 67, and his contributions will total $160,000. No matter what your age and annual return assumptions are, one thing is very clear – the earlier you start saving the better!
Before you get too excited and start writing your IRA custodian or administrator checks to open Roth IRAs for your minor children, you must make sure that they qualify to make a contribution. In order to contribute to a Roth IRA, a single individual must have earned income (compensation) at least in the amount of the contribution and Adjusted Gross Income of no more than $122,000 (for 2011). For example, if your daughter earns $1,000 babysitting in 2011, she can contribute a maximum of only $1,000 to her Roth IRA, even though the contribution limit for individuals under age 50 is $5,000.
How can a minor earn money so they qualify to contribute to a Roth IRA? The younger your child is, the more difficult it will be to justify compensation if the IRS questions the contribution. I have heard of parents hiring their minor children as a model for advertising purposes in the parents’ trade or business, but if you intend to do this make sure that you actually use the photos in your advertising. Keep track of how and when you use the photos, and have adequate documentation in your file as to what reasonable compensation would be for a model doing an advertising shoot with unlimited use of the photos. By the age of 8 or 9 children can be of some use to their parents’ businesses by doing things like cleaning up trash in the yard of rent houses, collating materials if the parent teaches classes, stuffing and stamping envelopes, or other menial tasks. At age 7 my daughter helped me with artwork to put on t-shirts by carefully writing in crayon “Do you have a self-directed IRA? I do!” I then had her wonderful artwork turned into a silk screen for the back of t-shirts with my company logo on the front. I gave away hundreds of the shirts to my clients. With the unusual writing on the back of the shirts, people asked a lot of questions about self-directed IRAs and it turned out to be one of my most effective advertising campaigns! Other ways for minors to earn money include cutting grass, babysitting, or working at restaurants and offices when they are a little older. If you are hiring your minor children in your own business, be sure that you always document the time spent working and pay them a reasonable wage. The importance of good records cannot be overstated.
The next questions I get asked when discussing Roth IRAs for minors are “What is the tax effect of my child earning compensation?” and “Does my child have to file a tax return?” I will briefly summarize the rules here, but always check with your CPA or tax professional. More information may also be found in IRS Publication 929, Tax Rules for Children and Dependents. A minor child who is a dependent on someone else’s tax return cannot claim a dependency exemption, but can still claim the standard deduction on their tax return if they are required to file. The standard deduction for a single dependent minor varies between $950 and $5,700 for 2010, depending on the type and amount of income. In general, for 2010 a dependent minor must file a tax return if 1) unearned income, such as interest and dividends, was over $950, 2) earned income was over $5,700, or 3) if the minor has both earned income and unearned income, the gross income was more than the larger of $950 or the earned income (up to $5,400) plus $300. If the dependent minor worked at an employer who withheld income taxes from their paycheck, in most cases they will want to file a return to collect a refund of this amount, even if there was no filing requirement.
There are situations where a dependent minor has to file a tax return regardless of the above filing requirements. One of the more common circumstances is when the dependent minor has net earnings from self-employment (such as from babysitting or cutting grass) of $400 or more. Net earnings from self-employment for IRA contribution purposes are calculated by taking the net Schedule C income and subtracting one-half of the self-employment taxes due and the contribution to any self-employment retirement plan such as a SEP IRA. If this amount is $400 or more, the dependent minor will owe Social Security and Medicare tax on that income and will have to file a tax return to pay the tax. For example, a recent tax client of mine who was 18 years old and still a dependent on her mother’s tax return earned $3,183 doing clerical work, for which she received a 1099-MISC. She was not treated as an employee by the person who hired her, and she was required to file a dependent tax return to report this income. Because her Adjusted Gross Income was below $5,700 she owed no federal income tax. Unfortunately, she still owed $487 in Social Security and Medicare taxes. If she had been treated as an employee, the employer would have paid its portion and withheld her portion of the Social Security and Medicare tax from her paycheck. In that case she would not have had to file a federal tax return, unless she wanted to claim a refund for any federal income taxes withheld.
There is an interesting exception to the requirement that a dependent minor pay Social Security and Medicare tax on their earned income. If a child under age 18 works in their parent’s trade or business and their parent’s business is either a sole proprietorship or a partnership in which the parents are the only partners, the income is exempt from Social Security and Medicare taxes, as well as federal unemployment taxes (FUTA). This exception does not apply if the business is incorporated or if the partnership includes persons other than parents. The exemption is extended to those under age 21 for work other than in a trade or business, such as domestic work in the parent’s private home. So if a minor earns compensation of less than $5,700 working in their parent’s trade or business or for domestic work in the parent’s private home and they have no other income, no federal income tax or Social Security and Medicare taxes would be due. This means that no tax return would have to be filed, but they would still qualify to contribute to a Roth IRA up to the amount of their earned income, subject to the $5,000 maximum contribution! However, just to be safe it may be advisable to go ahead and file a zero tax due return for documentation purposes. Always check with your CPA or tax advisor to find out if your child will owe state or local income taxes on this income. More information on the family employee exception to Social Security and Medicare taxes may be found in IRS Publication 15, Circular E, Employer’s Tax Guide, Chapter 3.
What you can do with the money once in a Roth IRA? The beauty of a self-directed IRA is that even small amounts can be invested in non-traditional investments. There are at least four ways a small Roth IRA can be invested. The Roth IRA may be combined with IRAs of other people to make a single investment. The most IRAs I have seen participate in a single note investment was 10 different accounts, with the smallest IRA investor contributing only $2,000. That note had a yield of 12% per year! Another investment which is common in small IRA accounts is an option to buy real estate. Once you have an option, you may let it lapse, exercise the option and close on the property, sell the option to a third party for a fee if the option agreement allows this, or even release the option for a cancellation fee from the property owner. Another variation on this idea is for the Roth IRA to enter into a sales contract, then assign that contract to a third party for a fee. Finally, the IRA could buy a property with a loan, either from taking over the property subject to the seller’s existing financing, negotiating non-recourse seller financing, or obtaining a non-recourse loan from a private party or another non-disqualified IRA. However, if the IRA either owns debt-financed property or operates a business of any type (including a real estate dealer business), it may be required to file IRS Form 990T and pay Unrelated Business Income Tax (UBIT). Always be sure and have your child’s IRA pay the taxes if they are due. It is great to use the tax law to your advantage, but do not abuse the law, because the IRS has what it takes to take what you have.
If your child qualifies, there is no doubt that one of the best things you can do for them is to open a Roth IRA. Perhaps the best part of this strategy is the time you will spend with your child teaching them the benefits of saving early and the methods of investing their money wisely. This is truly a win-win situation for both you and your child. Happy investing!